Economics of the Accounting Environment

1. Economics of the Accounting Environment Krishnamurthy Surysekar ACG 6935 Introduction to Financial Accounting International MBA Program FIU Fall 2004

2. Overview of the Presentation • The economic context of accounting • Accounting Numbers Matter • Accounting as an information system • Key financial statements • GAAP and the audit report • Accounting Environment

3. Accounting Numbers Matter • “Can accounting that follows the stated rules still be unreliable ? In other words, is there a gap in GAAP ?… even though a penny a share difference in quarterly profits can send a stock price soaring or sinking, quarterly financial reports are far from the precise things that investors dream them to be.” New York Times, December 31, 2002, p. C1

4. Accounting Numbers Matter - Tyco • “…Aggressive bookkeeping practices, which treated current expenses at ADT as long-term capital costs, will cut about $125 million from Tyco's reported pretax results for the year ended Sept. 30, according to the Journal.”

5. Introduction • Accounting as an information system • Key stake holders • External • Investors, Creditors, Regulators, Tax authorities, Customers, Unions, etc. • Internal • Managers • Three basic types of business activities important for accounting • Operating, Investing and Financing

6. Introduction • Financial accounting • External user focus, mostly financial information that is ex-ante • Managerial Accounting • Internal user focus, financial and non-financial information that is ex-ante and ex-post • Financial Statements • Income Statement, Balance Sheet, Statement of Owner’s Equity, Statement of Cash Flows

7. User Orientation of Financial Statements • Most important objective is to provide information of value to users • Should we invest in this company ? • Should we extend credit or lend to this company ? • Should we do business with this company ?

8. Key Financial Statements • Income Statement • Statement of earnings, Statement of operations • Flow – what happened over a period of time, usually a year • Revenues, Expenses, Net Income or Net Loss • Balance Sheet • Statement of Financial Position • Stock – What is the position at a point in time, usually on Dec. 31 • Assets, Liabilities and Owners’ Equity • Assets = Liabilities + Owners’ Equity

9. Key Financial Statements • Statement of Owners’ Equity • How Owners’ Equity Changed during a period • Fresh infusion of cash, Net Income or Net Loss, Owner withdrawals (or Dividends) • Statement of Cash Flows • Net cash flows from operating , investing and financing activities • Although not a statement in itself, “Notes to the accounts” is a must-read – sets out policies followed in the accounting system

10. Income Statement XYZ Corp. Income Statement for the year ending 12/31/xx Revenues XX Expenses XX Income tax expense related to continuing operations XX Income from Continuing Operations XX Income(Loss) from discontinued operations (net of taxes) XX Income (Loss) from Extraordinary Items (net of taxes) XX Cumulative Effect of Change in Accounting Principle (net of taxes) XX Net Income XX Other Comprehensive Income XX Comprehensive Income XX

11. The Income Statement –Some Details • Income from continuing operations • Single and multi-step • Single-step (all revenues and gains followed by all expenses and losses) • Multi-step (classified; eg. Sales, cost of goods sold, gross margin, operating expenses, other revenues, other expenses)

12. Discontinued operations • Assets, results of operations and activities of the segment must be clearly distinct from the rest of the entity • Line of business must be discontinued in entirety • NOT: Change of location, change due to technological improvements • Net of income tax effect

13. Example of Disclosure on Discontinued Ops. • Spinoff of AT&T Broadband (Annual Report 2002) For the years ended Dec. 31 2002 2001 2000 ($ millions) AT&T Broadband $(14,440) $(4,202) $(5,399) (net of income tax benefits of $6,002, $3,873 and $1,671)

14. Extraordinary Items • Both unusual AND infrequent • Not related to ordinary and typical activity • Not likely to occur in the foreseeable future • Presented net of income tax effect • NOT: Write-down of inventories, write-off of receivables, foreign currency translation gains/losses, effects of strikes • Example: Weyerhaeuser lost $36 million due to volcanic activity at Mt. St. Helens that destroyed standing timber, logs, buildings, equipment and transportation systems.

15. Effect of changes in accounting principle • Cumulative effect of change from one principle to another • Change in depreciation method • Changes in inventory valuation method

16. Other comprehensive income • An attempt to bring accounting income closer to economic income • Consider items that affect owners’ equity but not routed through the income statement • Examples: foreign currency translation gains and losses, certain holding gains and losses on investments, etc.

17. The Balance Sheet XYZ Corp. Balance Sheet December 31, xxxx Assets Current assets Long-term investments Plant, property, and equipment, net Deferred tax assets Intangible and other assets Total assets

18. The Balance Sheet (continued) Liabilities and Shareholders’ Equity Current liabilities Accrued expenses Deferred tax liabilities Long-term debt Total liabilities Capital stock Additional paid-in capital Retained earnings Accumulated other comprehensive Income Total shareholders’ equity Total liabilities and shareholders’ equity

19. The Statement of cash flows XYZ Corp. Statement of cash flows For the year ended 12/31/xxxx Net cash flow from operating activities xxx Net cash flow from investing activities xxx Net cash flow from financing activities xxx Net increase/decrease in cash xxx Cash and cash equivalents at the beginning of year xxx Cash and cash equivalents at the end of year xxx Schedule of non-cash investing and financing activities:

20. GAAP • Generally Accepted Accounting Principles • Guidelines, but very powerful • In the USA, what FASB (Financial Accounting Standards Board) says is GAAP • FASB follows due process, and there is enough opportunity for corporations and accounting firms, as well as other interested parties, to provide input

21. The Auditors • Generally three paragraphs to the audit report • What did we do and not do ? • How did we do it ? • What did we find ? • Incentive Problems • Hired and paid by the Board of Directors (effectively by management) • Investors (current and prospective) depend on independence from the management

22. The Audit Report-A Sample • We have audited the accompanying consolidated statements……. These statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these statements based on our audit • We conducted our audit based on audit standards generally accepted in the United States…. We believe that our audits provide a reasonable basis for our opinion.

23. The Audit Report – A Sample (cont’d) • In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of …..,the consolidated results of their operations and cash flows…..in conformity with accounting principles generally accepted in the United States. • Qualifications are generally in the third paragraph. • A management letter accompanies the audit report, assuring the integrity of the accounting system, the existence of internal controls, etc.

24. Key Players • Securities and Exchanges Commission (SEC), Financial Accounting Standards Board (FASB), The Congress, American Institute of Certified Public Accountants (AICPA), Institute of Management Accountants (IMA), Financial Executives Institute (FEI) • SEC is a government agency and regulates securities markets in USA • FASB determines what are generally accepted accounting principles (GAAP) • AICPA and IMA are the professional organizations representing the CPAs and CMAs

25. Key Players • The Congress legislates and has delegated the “policing” role to the SEC. Has now created the Accounting Oversight Board, offshoot of Andersen, Enron, WorldCom and other corporate accounting scandals • The Accounting Oversight Board • Inspect, investigate and discipline accounting firms • Not a government agency, but subject to overall superintendence by SEC • Five full-time members, max. two accountants, not on corporate boards

26. Conceptual Framework • Objectives of Financial Reporting (broadest level) • Qualitative characteristics of accounting information and elements of financial statements (second level – more detailed) • Assumptions, Principles and Constraints (third level, most detailed)

27. Conceptual Framework • Objectives of financial reporting • Useful for investment and credit decisions • Help assess amount, timing and uncertainty of future cash flows • Report on economic resources, claims against those resources, and changes in them

28. Conceptual Framework • Qualitative characteristics of accounting information and elements of financial statements • Information should be relevant and reliable • The cost of producing information should be less than the benefits of doing so • There must be a minimum threshold, below which disclosure of information is not material • “deemed immaterial” in annual reports • Aggregating customer dues under one account • Assumptions, Principles and Constraints

29. Assumptions • Economic Entity • Accounts of the company are kept distinct from those of its owners/shareholders • Personal residence of a business owner is not an asset of the business • Going concern • The company is expected to exist to perpetuity • Long-lived assets are reported at their acquisition cost • Monetary unit • Economic activity measured with money • Periodicity • Divide activity into time periods

30. Principles • Historical cost • A machine is accounted at what the company paid for it, not its suggested retail price • Revenue recognition • Earned • Realized or realizable • Enron troubles – phantom transactions booked as revenues

31. Principles • Matching • Expenses are matched against revenues earned in a period • Accrue warranty costs, even though not incurred • Charge depreciation on long-lived assets • Full disclosure • Basically applies to events that cannot fit the criteria to make it into the body of the financial statements • Pending lawsuits against the company • Significant changes in accounting principle (both accepted) • Notes and supplementary information

32. Constraints • Cost-benefit relationship • Contentious area • Costs are easy to measure, but not benefits • Materiality • Minimum threshold, relative size and importance • Qualitative and quantitative criteria • Industry practices • Concession to unique features of an industry Ex. recognizing revenue before project completion on long-term construction contracts

33. Constraints • Conservatism • When in doubt choose an accounting method that is least likely to overstate profits and assets • Example: Lower of cost or market value for valuing inventories • Assumptions, Principles and Constraints are practical implementation guidelines • Lot of judgment calls to be made

34. Revenue Recognition • Definition of Revenue Increases in assets or decreases in liabilities during a period from delivering goods, rendering services, or other activities constituting the enterprise’s central operations (Statement of Financial Accounting Concepts 6)

35. Revenue Recognition • When is something “revenue” ? • For economists, everything that causes the change in an entity’s economic value • For accountants, it is a subset of above • Specific events that give rise to recognizable elements of revenue and expenses in a reporting period

36. Revenue Recognition • Generally (there are important exceptions) two conditions: • Did you earn it ? • Has the product been shipped/received by customer or has the service been provided ? • Is the money realized or realizable ? • Have you raised an invoice ? • Interest is earned with passage of time (no reciprocity when recognized)

37. Revenues versus Gains • Gains result from peripheral transactions • Eg. Sale of assets, Increases in market values of investment securities held • Gains are reported on a net basis • Earning is less important than being realized or realizable

38. Examples of revenue recognition issues • “Stuffing the channel” • Offer deep discounts to distributors and make them overbuy, book revenue now • Future results will be adverse when distributors return the unsold merchandise • Software industry – eg. Lucent Technologies • “Loading the trade” • Similar practice – cigarette industry in 1980s

39. Important exceptions to Revenue Recognition General Rule • Two important exceptions • Long-term construction contracts – revenue can be recognized even before the completion of the contract • Sunbeam fires auditors over this • Installment Sales – revenue can be recognized only as collections of customer dues take place

40. Wal-Mart’s 2001 Annual Report • SEC’s Staff Accounting Bulletin 101 – Revenue Recognition • Previously, Sam’s Club Membership fee was recognized as revenue when received (even though for 12 months ahead of time) • Now, it is recognized over the time the fee pertains to • Fee received in advance is “deferred revenue” which is a liability

41. International Accounting Harmonization • Increase the compatibility of accounting practices – limit the amount of variability • International financial information can be better compared • Cost savings from not having to spend time understanding different accounting 41systems • Problems – why sacrifice impact of local social and political systems ? • Are powerful commercial interests imposing their wishes indiscriminately ?

42. International Accounting Standards Committee (1973) • Independent private-sector agency • 41 standards so far • Initially more descriptive than prescriptive (Choi et al, 1999, p.255) – described various alternative treatments • Now addressing the more substantive issues and the creating of standards

43. IAS 16 – Property Plant and Equipment • Initial measurement of the asset is at cost (what you paid to get it and bring it to the point of its intended use) • Subsequent updating of value to current cost permitted • Contrast with US GAAP: No revaluation of PPE to current market price permitted