Ch 06 - Analyzing Operating Activities

8/20/2019 Ch 06 - Analyzing Operating Activities

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Chapter 06 - Analyzing Operating Activities

Chapter 6

Analyzing Operating Activities

REVIEW

Income is the residual of revenues and gains less expenses and losses !et income ismeasured using the accrual "asis of accounting Accrual accounting recognizesrevenues 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((revenues$ expenses$ gains$ and losses We analyze income and its components toevaluate company performance, assess risk exposures, and predict amounts, timing,and uncertainty of future cash flows While )"ottom line) net income frames our analysis$ income components provide pieces of a mosaic revealing the economic portraitof a company %his chapter examines the analysis and interpretation of incomecomponents We consider current reporting re*uirements and their implications for our analysis of income components We descri"e ho# #e might usefully apply analyticalad+ustments to income components and related disclosures to "etter our analysis Wedirect special attention to revenue recognition and the recording of ma+or expenses andcosts ,urther use and analysis is made of income components in -art %hree of the"oo.

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O/%0I!E

•

Income 1easurementConcept of Income

1easuring Accounting Income

Alternative Classification and Income 1easures

• !on(recurring itemsExtraordinary Items

2iscontinued Operations

Accounting Changes

3pecial Items

• Revenue and 4ain Recognition4uidelines for Revenue Recognition

/ncertainty in Revenue Collection

Revenue When Right of Return Exists

,ranchise Revenues

-roduct ,inancing Arrangements

Revenue under Contracts

Analysis Implications of Revenue Recognition

• 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

• Appendix 6A Earnings per 3hare Computation and Analysis

• Appendix 65 Economics of Employee 3toc. Options

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A!A073I3 O58EC%IVE3

• Explain the concepts of income measurement and their implications for analysis ofoperating activities

• 2escri"e and analyze the impact of non(recurring items ( including extraordinaryitems$ discontinued segments$ accounting changes$ and restructuring charges and#rite(offs

• Analyze revenue and expense recognition and its ris.s for financial analysis

• Analyze deferred charges$ including expenditures for research$ development$ andexploration

•

Explain supplementary employee "enefits and analyze disclosures for employeestoc. options &E3Os'

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

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

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

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9/E3%IO!3

: %he income statement portrays the net results of operations of an enterprise 3inceresults are #hat enterprises are esta"lished to achieve and since their value is$ inlarge measure$ determined "y the size and *uality of these results$ it follo#s that theanalyst attaches great importance to the income statement

; Income summarizes in financial terms the operating activities of a company Incomeis the amount of revenues and gains for the period in excess of expenses and losses$all computed under accrual accounting Income provides a measure of the change inshareholder #ealth for a period and an indication of a company<s future earningpo#er Accounting income differs from cash flo#s "ecause certain revenues andgains are recognized in periods "efore or after cash is received and certain expensesand losses are recognized in periods "efore or after cash is paid

= Economic income is net cash flo#s plus the change in the present value of futurecash flo#s Another similar concept$ the >ic.sian concept of income$ considers

income for the period to "e the amount that can "e #ithdra#n from the company in aperiod #ithout changing the net #ealth of the company >ic.sian income e*uals cashflo# plus the change in the fair value of net assets

? Accounting income is the excess of revenues and gains over expenses and lossesmeasured using accrual accounting As such$ revenues &and gains' are recognized#hen earned and expenses &losses' are matched against the revenues &and gains'

@ !et income is the excess of the revenues and gains of the company over theexpenses and losses of the company !et income often is called the "ottom line$Balthough that is a misnomer "ecause certain unrealized holding gains and losses arecharged directly to e*uity and "ypass net income Comprehensive income includes

all changes in e*uity that result from non(o#ner transactions &excluding items suchas dividends and stoc. issuances' Items creating differences "et#een net incomeand comprehensive income include unrealized gains and losses on availa"le for salesecurities$ foreign currency translation ad+ustments$ minimum pension lia"ilityad+ustments$ and unrealized holding gains or losses on derivative instrumentsComprehensive income is the ultimate "ottom lineB income num"er Continuingincome is a measure of net income earned "y ongoing segments of the companyContinuing income differs from net income "ecause continuing income excludes theincome or loss of segments of the company that are to "e discontinued or sold &italso excludes extraordinary items and effects from changes in accountingprinciples'

6 2etails regarding comprehensive income are reported "y the vast ma+ority of companies in the statement of stoc.holders< e*uity rather than the income statement

Core income is a measure of income that excludes all non(recurring items that arereported as separate items on the income statement

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D Operating income is a measure of firm performance from operating activitiesExamples of operating income include product sales$ cost of product sales$ andselling$ general$ and administrative costs !on(operating income includes allcomponents of income not included in operating income Examples of non(operatingincome include interest revenue and interest expense

Operating versus non(operating and recurring versus non(recurring are distinctdimensions of classifying income While there is overlap across selected items$ thesedimensions reflect different characteristics of "usiness activities ,or example$ theinterest income and interest expense of most companies recur in net incomeF hence$they are included in recurring income >o#ever$ these items are non(operating innature 3imilarly$ non(recurring items such as restructuring charge are operating innature

:G Accounting standards & APB 30 ' restricted the use of the )extraordinary) category "yre*uiring that an extraordinary item "e both unusual in nature and infre*uent inoccurrence %hese attri"utes are defined as follo#s

a /nusual nature of the underlying event or transaction should possess a highdegree of a"normality and "e of a type clearly unrelated to$ or only incidentallyrelated to$ the ordinary and typical activities of the entity$ ta.ing into account theenvironment in #hich the entity operates

" Infre*uency of occurrence of the underlying event or transaction should "e of atype 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 an 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 as discontinued operations$ the assets and "usiness activities of thedivested segment must "e clearly distinguisha"le from the assets and "usinessactivities of the remaining entity Accounting and reporting for discontinuedoperations is t#o(fold ,irst$ the income statement for the current and prior t#o yearsare restated after excluding the effects of the discontinued operations from the lineitems that determine continuing income 3econd$ gains or losses pertaining to thediscontinued operations are reported separately$ net of related tax effects An analystshould separate and ignore discontinued operations in predicting future performanceand financial condition

:; %o *ualify as a prior period ad+ustment$ an item must meet the follo#ingre*uirements

• 1aterial in amount

• 3pecifically 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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:= 2istortions in revenues &gains' and expenses &losses' can arise from severalaccounting sources %hese include choices in the timing of transactions &such asrevenue recognition and expense matching'$ selections from the variety of generallyaccepted principles and methods availa"le$ the introduction of conservative or aggressive estimates and assumptions$ and choices in ho# revenues$ gains$

expenses$ and losses are classified and presented in financial statements 4enerally$a company #ishing to increase current income at the expense of future income #illengage in one or more of the follo#ing practices&a' It #ill choose inventory methods that allo# for maximum inventory carrying values

and minimum current charges to cost of goods or services sold&"' It #ill choose depreciation methods and useful lives of property that #ill result in

minimum current charges as depreciation expense&c' It #ill defer all managed costs to the future such as$ for example pre(operating$

moving$ rearrangement and start(up costs$ and mar.eting costs 3uch costs#ould "e carried as deferred charges or included #ith the costs of other assetssuch as property$ plant$ and e*uipment

&d' It #ill amortize assets and defer costs over the largest possi"le period 3uch

assets include good#ill$ leasehold improvements$ patents$ and copyrights&e' It #ill elect the method re*uiring the lo#est possi"le pension and other

employment compensation cost accruals&f' It #ill inventory rather than expense administrative costs$ taxes$ and similar items&g' It #ill choose the most accelerated methods of income recognition such as in the

areas of leasing$ franchising$ real estate sales$ and contracting&h' It immediately #ill recognize as revenue$ rather than defer the ta.ing up of

"enefits$ items such as investment tax credits&i' Companies that #ish to manageB the size of accounting income can regulate the

flo# of income and expense "y means of reserves for future costs and losses

:? &:' 2epreciation

a Straight ine %his is calculated "y ta.ing the salvage value &3' from theoriginal 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 depreciation formula is &C(3' x&H7'F #here C and 3 are the same as a"ove$ is the remaining 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) &that is$ for a @(year asset$ 7J@L?L=L;L:J:@'

" 3traight line is easily understood and provides level depreciation and earningseffects %he sum(of(the(yearsK(digits gives heavier #eight to earlier years andcauses 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

&;' Inventorya %&' &last(in$ first(out' method %he 0I,O method assumes the inventory

employed are those most recently ac*uired &%&' &first(in$ first(out' method%he ,I,O method assumes the first inventory items ac*uired are used first

" %he effect on earnings depends on #hether the economy is in an inflationaryor deflationary period In times of inflation &the more usual case'$ 0I,Oinventory accounting #ould result in lo#er earnings "eing reported than #ould"e the case had ,I,O "een employed

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c&=' Installment sales

a Accrual method Assumes income is recognized #hen the sale is made&earned' %nstallment method Assumes income is recognized only #hen cashis received as the various installments come in

" %he installment method is commonly used for tax purposes #hile the accrual

method is employed in financial statements %he accrual method #ould resultin a higher earnings figure "eing reported than the installment method

:@ %hree different types of accounting changes include&a' Changes in accounting principle&"' Changes in accounting estimate&c' Changes in reporting entity

:6 3pecial items refer to transactions and events that are unusual or infre*uent$ not"oth %hese items are reported as separate line items on the income statement "eforecontinuing income Examples of special items include restructuring charges$impairments of long(lived assets$ and asset #rite(offs

: 3pecial &one(time' charges usually receive less attention "y investors "ecause it

often is "elieved that such charges #ill not recur in the future As a result$ companiesoften include as much operating expense and loss as possi"le in special chargeshoping that investors #ill focus on income "efore special charges that excludesthese expenses and losses If investors do focus on income "efore these charges$company value may "e erroneously perceived to "e higher than is supported "y thefundamentals

:D 1any special charges should "e vie#ed as operating expenses that need to "ereflected in permanent income Essentially$ many special charges are either corrections of understated past expenses or investments for improved future

profita"ility As such$ analysts should ad+ust their income measurements to includespecial charges in operating income

: %he follo#ing criteria exemplify the rules that have "een esta"lished to prevent thepremature anticipation of revenue Realization is deemed to ta.e place only after thefollo#ing conditions have "een met&a' %he earning activities underta.en to create revenue are su"stantially completeF

for example$ no significant effort is necessary to complete the transaction&"' In the case of a sale$ the ris. of o#nership has effectively passed to the "uyer&c' %he revenue$ as #ell as the associated expenses$ can "e measured or estimated

#ith su"stantial accuracy&d' %he revenue recognized should normally result in an increase in cash$

receiva"les$ or mar.eta"le securities and$ under certain conditions$ in an increasein inventories or other assets$ or a decrease in a lia"ility

&e' %he "usiness transactions giving rise to the income should "e at armKs(length #ithindependent parties &that is$ not #ith controlled parties'

&f' %he transactions should not "e su"+ect to revocation$ for example$ carrying theright of return of merchandise sold

;G S&AS () &)Revenue Recognition When Right of Return Exists)' specifies that revenuefrom sales transactions in #hich the "uyer has a right to return the product should "erecognized at the time of sale only if all of the follo#ing 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 &not contingent onresale of the product'

• In the event of theft or physical damage to the product$ the "uyerKs o"ligation tothe seller #ould not "e changed

• %he "uyer ac*uiring the product for resale has economic su"stance apart fromthat provided "y the seller

• %he seller does not have significant o"ligations for future performance to directly"ring a"out resale of the product

• -roduct returns can "e reasona"ly estimatedIf these conditions are not met$ revenue recognition is postponedF if they are met$sales revenue and cost of sales should "e reduced to reflect estimated returns andexpected costs or losses should "e accrued *ote %he 3tatement does not apply toaccounting for revenue in &a' service industries if part or all of the service revenuemay "e returned under cancellation privileges granted to the "uyer$ &"' transactionsinvolving real estate or leases$ or &c' sales transactions in #hich a customer mayreturn defective goods such as under #arranty provisions

;: 3ome of the factors that might impair the a"ility to predict returns &#hen right of return exists in transactions' are &:' suscepti"ility to significant external factors$such as technological o"solescence or s#ings in mar.et demand$ &;' long returnprivilege periods$ and &=' a"sence of appropriate historical return experience

;; S&AS (+ &)Accounting for -roduct ,inancing Arrangements)' is concerned #ith theissue of #hether revenue has "een earned A product financing arrangement is anagreement involving the transfer or sponsored ac*uisition of inventory that$ althoughit resem"les a sale$ is in su"stance a means of financing inventory through a secondparty ,or example$ if a company transfers inventory to another company in anapparent sale$ and in a related transaction agrees to repurchase the inventory at alater date$ the arrangement may "e a product financing arrangement rather than asale and su"se*uent purchase of inventory If the party "earing the ris.s andre#ards of o#nership transfers inventory to a purchaser$ and in a related transactionagrees to repurchase the product at a specifiedprice$ or guarantees some specified resale price for sales of the product to outsideparties$ the arrangement is a product financing arrangement and should "eaccounted for as such

;= %he percentage!of!completion method is preferred #hen estimates of costs tocomplete along #ith estimates of progress to#ard completion of the contract can "emade #ith reasona"le dependa"ility A common "asis of profit estimation is to recordthat part of the estimated total profit that corresponds to the ratio that costs incurredto date "ears to expected total costs Other methods of estimation of completion can"e "ased on units completed or on *ualified engineering estimates or on unitsdelivered

%he completed!contract method of accounting is prefera"le #here the conditionsinherent in the contract present ris.s and uncertainties that result in an ina"ility toma.e reasona"le estimates of costs and completion time -ro"lems under thismethod concern the point at #hich completion of the contract is deemed to haveoccurred as #ell as the .ind of expenses to "e deferred ,or example$ somecompanies defer all costs to the completion date$ including general andadministrative overhead #hile others consider such costs as period costs to "eexpensed as they are incurred

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/nder either of the t#o contract accounting methods$ losses &present or anticipated' must "e fully provided for in the period in #hich the loss first "ecomesapparent

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;? %he recording of revenue is the first step in the process of income determination andis a step for #hich the recognition of any and all revenue depends %he analystshould "e particularly in*uisitive a"out revenue recognition policies and procedures3ome specific aspects include the 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 resultingreceiva"le 3pecial collection pro"lems exist #ith respect to installment sales$ realestate sales$ and franchise sales -ro"lems of collection exist$ ho#ever$ in the case of all sales and the analyst must "e alert to them &;' %he analyst must also "e alert tothe pro"lems related to the timing of revenue recognition %he present rules generallydo not allo# for recognition of profit in advance of saleMsuch as #ith increases inmar.et value of property such as land or e*uipment$ the accretion of values ingro#ing tim"er$ or the increase in the value of inventories are not recognized in theaccounts As a conse*uence$ income #ill not "e recorded "efore sale and the timingof sales is a matter that lies #ithin the discretion of management %hat$ in turn$ givesmanagement a certain degree of discretion in the timing of profit recognition &=' Inthe 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.ingup 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 amongcompanies in the same industry is underta.en

;@ S&AS &)Accounting for Research and 2evelopment Costs)' offers a simple solutionto the complex pro"lem of accounting for research and development costs !amely$it re*uires that RN2 costs "e charged to expense #hen incurred It defines researchand 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 anexisting 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 andmar.et research and testing activities

%he 5oard recommended the follo#ing accounting treatment for RN2 costs&a' %he ma+ority of expenditures incurred in research and development activities as

defined a"ove constitutes the costs of that activity and should "e charged toexpense #hen incurred

&"' Costs of materials$ e*uipment$ and facilities that have alternative future uses &inresearch and development pro+ects or other#ise' should "e capitalized astangi"le assets

&c' Intangi"les purchased from an external party for RN2 use that have alternativefuture uses should also "e capitalized

&d' Indirect costs involved in ac*uiring patents should "e capitalized as #ell

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Elements of costs that should "e identified #ith RN2 activities are&a' Costs of materials$ e*uipment$ and facilities that are ac*uired or constructed for a

particular research and development pro+ect and purchased intangi"les$ that haveno alternative future uses &in research and development pro+ects or other#ise'

&"' Costs of materials consumed in research and development activities$ the

depreciation of e*uipment or facilities$ and the amortization of intangi"le assetsused in research and development activities that have alternative future uses

&c' 3alaries and other related costs of personnel engaged in RN2 activities&d' Costs of services performed "y others&e' A reasona"le allocation of indirect costs 4eneral and administrative costs that

are not clearly related to RN2 activities should "e excluded

%he specific disclosure re*uirements as stipulated "y 3,A3 ; are &:' for each incomestatement presented$ the total RN2 costs charged to expense is to "e disclosed$ and&;' government(regulated companies that defer RN2 costs in accordance #ith theaddendum to 3,A3 ; must ma.e certain additional disclosures to that effect

;6 ,or an analyst to form a relia"le opinion on the *uality and the future potential valueof research outlays$ the analyst needs to .no# a great deal more than the totals of periodic research and development outlays %he analyst needs information on &:' thetypes of research performed$ &;' the outlays "y category$ &=' the technical feasi"ility$commercial via"ility$ and future potential of each pro+ect assessed and reevaluated atthe time of each periodic report$ and &?' information on a companyKs success(failureexperience in its several areas of research activity to date Of course$ presentdisclosure re*uirements #ill not give the analyst such information and it appears that$except in cases of voluntary disclosure$ only the investor or the lender #ith thenecessary clout #ill "e a"le to o"tain such information In general$ one can assumethat the outright expensing of all research and development outlays #ill result inmore conservative "alance sheets and fe#er "ad(ne#s surprises stemming from the

#holesale #rite(offs of previously capitalized research and development outlays>o#ever$ the analyst must realize that along #ith a lac. of .no#ledge a"out futurepotential sHhe may also "e una#are of the potential disasters that can "efall anenterprise tempted or forced to sin. ever greater amounts of funds into research anddevelopment pro+ects #hose promise #as great "ut #hose failure is neverthelessinevita"le

; One of the most common solutions applied "y analysts to the complex pro"lem of theanalysis of good#ill is to simply ignore it %hat is$ they ignore the asset sho#n on the"alance sheet /nfortunately$ "y ignoring good#ill$ analysts ignore investments of very su"stantial resources in #hat may often "e a companyKs most important assetIgnoring the impact of good#ill impairment losses on reported periodic income is nosolution 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 theeffects of accounting practices in this area on accounting income rather than dismissthem altogether

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;D

4ood#ill is measured "y the excess of cost over the fair mar.et value of tangi"le netassets ac*uired in a transaction accounted for as a purchase %hat is the theory of it%he financial analyst must "e alert to the ma.eup and the method of valuation of the4ood#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 itoff at a time #hen it #ould have the least serious impact on the mar.etKs +udgment of the companyKs earnings$ for example$ at a time of loss or reduced earnings /nder normal circumstances$ good#ill is not indestructi"le "ut is rather an asset #ith alimited useful life 3till$ #hatever the advantages of location$ mar.et dominance andcompetitive 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 suchevidence of continuing value as the profita"ility of units for #hich the good#illconsideration #as originally paid

; %he interest cost to a company is the nominal rate paid including$ in the case of

"onds$ the amortization of any "ond discount or premium A complication arises#hen companies issue converti"le de"t or de"t #ith #arrants$ thus achieving anominal de"t coupon cost that is "elo# the cost of similar de"t not carrying thesefeatures After trial pronouncements on the su"+ect and much controversy$ APB .(concluded in the case of converti"le de"t that the insepara"ility of the de"t ande*uity features is such that no portion of the proceeds from the issuance should "eaccounted for as attri"uta"le to the conversion feature In the case of de"t issued#ith stoc. #arrants attached$ the proceeds of the de"t attri"uta"le to the #arrantsshould "e accounted for as paid(in capital %he corresponding charge is to a de"tdiscount account that must "e amortized over the life of the de"t issue thusincreasing the effective interest cost

=G a S&AS 3( &)Capitalization of Interest Cost)' re*uires capitalization of interest costas part of the historical cost of )assets that are constructed or other#iseproduced for an enterpriseKs o#n use &including assets constructed or producedfor the enterprise "y others for #hich deposits or progress payments have "eenmade') Inventory items that are routinely manufactured or produced in large*uantities on a repetitive "asis do not *ualify for interest capitalization %heo"+ectives of interest capitalization$ according to the ,A35$ are &:' to measuremore accurately the ac*uisition cost of an asset$ and &;' to amortize thatac*uisition cost against revenues generated "y the asset

" %he amount of interest to "e capitalized is "ased on the entityKs actual "orro#ingsand 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 "orro#ings are not specific for the asset$ or the asset exceeds specific"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 allappropriate "orro#ings regardless of specific "orro#ings incurred to finance theasset

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c Interest capitalization is not permitted to exceed total interest costs for any 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 threeconditions are present &:' expenditures for the asset have "een made "y the

entity$ &;' #or. on the asset is in progress$ and &=' interest cost is "eing incurredInterest capitalization ceases #hen the asset is ready for its intended use

=: %he intrinsic value of an option is the amount "y #hich the mar.et value of theunderlying 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 topay today to purchase the option

=; %he fair value of an 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 dividend yield

== S&AS .3 re*uires that the company amortize the fair value of employee stoc.options &estimated using various option pricing models' at the grant date over theexpected life of the option %he cumulative amortization of all employee 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$ arecent revision of the standard$ S&AS .3- $ re*uires that the option compensationexpense "e charged to income Compensation expense may "e included in variousexpense categories such as cost of goods sold$ 34NA$ RN2 etc "ased on #hich areaof the company the respective employee #or.s for

=? %he economic cost of issuing options at the prevailing mar.et price are &:' theinterest cost$ #hich is that the employee is a"le to pay for the stoc. purchase many

years later using the current stoc. priceF and &;' cost of providing an option toexercise$ #hich arises "ecause the employee can share in the potential upside "ut isprotected from sharing in the potential do#nside ris.

=@ Option overhang refers to the intrinsic value of outstanding options &"oth exercisa"leand other#ise' as a proportion of the company<s mar.et value It is a measure of thevalue of potential dilution that arises from option grants to employees It measured "yaggregating the intrinsic value of all outstanding employee stoc. options$ using thecurrent stoc. price$ and dividing it "y the current mar.et capitalization of thecompany<s e*uity

=@ %he net income computed on the "asis of generally accepted accounting principles&also .no#n as )"oo. income)' is usually not identical to the )taxa"le income)computed on the entityKs tax return %his is due to t#o types of difference -ermanentdifferences &discussed here' and temporary$ or timing$ differences -ermanentdifferences result from provisions of the tax la# under #hich&a' Certain items may "e nontaxa"leMfor example$ income on tax exempt o"ligations

and proceeds of life insurance on an officer

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&"'&c' Certain deductions are not allo#edMfor example$ penalties for filing certain

returns$ government fines$ and officer life insurance premiums&d' 3pecial deductions granted "y la#Mfor example$ dividend exclusion on dividends

from unconsolidated su"sidiaries and from dividends received from other domestic corporations

=6 %he effective tax rate paid "y a corporation on its income #ill vary from the statutoryrate "ecause

• %he "asis of carrying property for accounting purposes may differ from that for tax purposes from reorganizations$ "usiness com"inations$ or other transactions

• !on*ualified and *ualified stoc.(option plans may result in "oo.(tax differences

• Certain industries$ such as savings and loan associations$ shipping lines$ andinsurance companies en+oy special tax 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

expensesWhat ma.es these differences and factors permanent is the fact that they do not haveany future repercussions on a companyKs taxa"le income %hus$ they must "e ta.eninto account #hen reconciling a companyKs actual &effective' tax rate to the statutoryrate

= S&AS .0+ &)Accounting for Income %axes)' esta"lishes financial accounting andreporting standards for the effects of income taxes that result from an enterpriseKsactivities during the current and preceding years$ and re*uires an asset and lia"ilityapproach S&AS .0+ re*uires that deferred taxes should "e determined separatelyfor each tax(paying component &an individual entity or group of entities that isconsolidated for tax purposes' in each tax +urisdiction %he determination includesthe follo#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 carry for#ard$ plus theremaining length of the carry for#ard period

• 1easure the total deferred tax lia"ility for taxa"le temporary differences$ using theapplica"le tax rate

• 1easure the total deferred tax asset for deducti"le temporary differences andoperating 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 ofavaila"le evidence It is more li.ely than not &a li.elihood of more than @G percent'that some portion or all of the deferred tax assets #ill not "e realized %he

valuation allo#ance should "e sufficient to reduce the deferred tax asset to theamount 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 taxla#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 or gains are included in taxa"le income later than they are included inpretax accounting income

&"' Expenses or losses are deducted in determining taxa"le income later than theyare deducted in determining pretax accounting income

&c' Revenues or gains are included in taxa"le income earlier than they are included in

pretax accounting income&d' Expenses or losses are deducted in determining taxa"le income earlier than they

are deducted in determining pretax accounting income

= %he components of the net deferred tax lia"ility or net deferred tax asset recognizedin a companyKs "alance sheet should "e disclosed %hese include the

• %otal of all deferred tax lia"ilities

• %otal of all deferred tax assets

• %otal valuation allo#ance recognized for deferred tax assetsAdditional disclosures include the significant components of income tax expenseattri"uta"le to continuing operations for each year presented #hich include$ for example• Current tax expense or "enefit• 2eferred tax expense or "enefit &exclusive of the effects of other components'

• Investment tax credits

• 4overnment grants &to the extent recognized as a reduction of income taxexpense'

• %he "enefits of operating loss carry for#ards

• %ax expense that results from allocating certain tax "enefits either directly tocontri"uted capital or to reduce good#ill or other noncurrent intangi"le assets of an ac*uired 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 of the "eginning(of(year "alance of a valuation allo#ance "ecause of a change in circumstances that causes a change in +udgment a"out therealiza"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 thestatutory 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 isgiven to the fact that a future o"ligation$ or loss of "enefits$ should "e discountedrather 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 theconceptual and implementation issues involved &;' Another fla# is that the 5oard

allo#ed parent companies to avoid providing taxes on unremitted earnings of su"sidiaries and other specialized exceptions to the re*uirements of deferred taxaccounting

?: A %he determination of the earnings level of an enterprise$ #hich is relevant to thepurpose of the analyst$ is a complex analytical process %he earnings figure can "econverted into a per(share amount that is useful in evaluating the price of thecommon stoc.$ its dividend coverage$ and the potential effects of dilution As #ithany 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 decisionma.ing

6-16




?; A Earnings per share data are used in ma.ing investment decisions %hey are used inevaluating the past operating performance of a company and in forming an opinionas to its future potential %hey are commonly presented in prospectuses$ proxymaterial$ and reports to stoc.holders$ and is the only financial statement ratio that is

audited %hey are used in the compilation of "usiness earnings data for the press$statistical services$ and other pu"lications When presented #ith formal financialstatements$ they assist the investor in #eighing the significance of a corporationKscurrent net income and of changes in its net income from period to period in relationto the shares an analyst holds or may ac*uire

Current 4AA- regarding E-3 conforms to international standards %he analystmust "e a#are that "asic E-3 does not ta.e into account securities that$ although notcommon stoc.$ are in su"stance e*uivalent to common stoc. %he analyst must ta.ecare to focus on diluted E-3$ #hich intends to sho# the maximum extent of potentialdilution of current earnings that conversions of securities could create

?= A 2iluted earnings per share is the amount of current earnings per share reflecting the

maximum dilution that #ould result from conversions$ exercises$ and other contingent issuances that individually #ould decreased earnings per share and in theaggregate yield a dilutive effect All such issuances are assumed to have ta.en placeat 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 thecommon stoc. can increase the num"er of common e*uivalent shares "y decreasingthe num"er of shares repurchasa"le under the treasury stoc. method

?6

A

S&AS .) has a num"er of fla#s and inconsistencies that the analyst must consider in interpreting E-3 data&a' %he computation of "asic E-3 completely ignores the potentially dilutive effects

of options and #arrants&"' %here is a "asic inconsistency in treating certain securities as the e*uivalent of

common stoc. for purposes of computing E-3 #hile not considering them as partof the stoc.holdersK e*uity in the "alance sheet Conse*uently$ the analyst #illhave difficulty in interrelating reported E-3 #ith the de"t(leverage positionpertaining to the same earnings

&c' 4enerally$ E-3 are considered to "e a factor influencing stoc. prices Whether options and #arrants are dilutive or not depends on the price of the commonstoc. %hus #e can get a circular effect in that the reporting of E-3 may influencethe mar.et price #hich$ in turn$ influences E-3 /nder these rules earnings maydepend on mar.et prices of the stoc. rather than only on economic factors #ithinthe enterprise In the extreme$ this suggests that the pro+ection of future E-3re*uires not only the pro+ection of earnings levels "ut also the pro+ection of futuremar.et prices

? A &a' Earnings per share data are used in ma.ing investment decisions %hey areused in evaluating the past operating performance of a company and in formingan opinion as to its future potential %hey are commonly presented inprospectuses$ proxy material$ and reports to stoc.holders %hey are used in thecompilation of "usiness earnings data for the press$ statistical services$ and other pu"lications When

6-17




presented #ith formal financial statements$ they assist the investor in #eighing thesignificance of a corporationKs current net income and of changes in its netincome from period to period in relation to the shares an analyst holds or mayac*uire

&"' Earnings per common share are not fully relevant to the valuation of 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 timespreferred dividends have "een earned and$ thus$ is a measure of the safety of thedividend as #ell as the safety of the preferred issue

6-18




EERCI3E3

Exercise 6(: &;@ minutes'

a Cash xxx4ain on dispositionP xxx!et assets of discontinued operations xxx

P &A loss on disposition #ould "e recorded as a de"it'

" Income &expense' related to discontinued operations include the operatingprofit &loss' recorded prior to sale and the gain &loss' on sale %hese arereported net of applica"le tax

c When estimating future earning po#er$ the results from discontinued

operations should not "e treated as recurring %his is important for anassessment of the permanent income of a company

d 3eparately reporting discontinued operations allo#s the analyst to vie# theresults of operations #ithout the segment that #ill not "e ongoing As aresult$ the analyst can "etter assess the permanent component of income$ for #hich results of discontinuing operations #ill "e excluded

Exercise 6(; &=G minutes'

a 5y the use of reserves$ a company can allocate costs in excess of actualexperience in the current period$ "ased on estimates of additional costs in thefuture$ 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 reserverather than reported as expenses in the companyKs income statement for those periods %he advantage to the company is that earnings trends can "e)smoothed$) and a cushion for future earnings can "e "uilt up during goodeconomic years for use during leaner periods %o the extent that sta"ility andpredicta"ility of earnings are mar.et virtues$ the companyKs common stoc.might "e accorded a higher multiple for these efforts$ in effect lo#ering thecost of capital to the company %he use of reserves "oth poses pro"lems for

the analyst and conflicts #ith some "asic accounting principles %heseinclude&:' /se of reserves contradicts the matching principle$ "y #hich revenues and

related costs should "e recognized in the same period&;' Reserving for future events &especially contingencies' is o"viously su"+ect

to estimate$ and accounting should attempt to record *uantifia"le value asmuch as possi"le

6-19




Exercise 6(;Mcontinued

&=' %he reserving techni*ue ma.es reported earnings less indicative of fundamental trends in the company %he effects of the economic cycle arereduced$ ma.ing correlation techni*ues &such as 4!- gro#th vs E-3gro#th' invalid %hese reported num"ers might mislead the uninformedBinvestor In contrast to the artificial smoothing referred to earlier$ thecompanyKs gro#th rate may "e exaggerated$ "y over(reserving for losses ina "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 itrecognizes a lia"ility that &:' li.ely exists in the relatively near futureMsuch ascosts 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 foreigncountry

" If the analyst is a"le to discern the impact of reserves$ sHhe should exclude the

reservesK impact from accounting income #hen assessing past trends Onlyoperating or normal earnings should "e compared over the short(term>o#ever$ over a longer period of time$ the losses against #hich reserves have"een ta.en should "e included In estimating future earnings$ the analystmust carefully consider the impact of reserves and exclude the impact #henforecasting normal earnings 5y doing this$ the analyst #ill have a "etter understanding of the true operations of the company In the valuation 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#arddepending on the degree of a"use of reserves

c 3everal examples of reserves are cited in the chapter Also$ students often"enefit from a revie# of "usiness magazines in attempting to identify suchreserves

&C,A Adapted'

Exercise 6(= &=@ minutes'

a A change from the sum(of(the(yearsK(digits method of depreciation to thestraight(line method for previously recorded assets is a change in accounting

principle 5oth the sum(of(the(yearsK(digits method and the straight(linemethod are generally accepted A change in accounting principle results fromadoption of a generally accepted accounting principle different from thegenerally accepted accounting principle used previously for reportingpurposes

6-20




Exercise 6(=Mcontinued

" A change in the expected service life of an asset arising "ecause of moreexperience #ith the asset is a change in accounting estimate A change inaccounting estimate occurs "ecause future events and their effects cannot "eperceived #ith certainty Estimates are an inherent part of the accountingprocess %herefore$ accounting and reporting for certain financial statementelements re*uires the exercise of +udgment$ su"+ect to revision "ased onexperience

c : %he cumulative effect of a change in accounting principle is the difference"et#een &:' the amount of retained earnings at the "eginning of the periodof change and &;' the amount of retained earnings that #ould have "eenreported at that date if the ne# accounting principle had "een used in prior periods

; ,A35 ;GG@ 3tatement Accounting Changes and Error CorrectionsBre*uires that effective in ;GG@$ companies should apply the retrospective

approachB to changes in accounting principle %hus$ all presented periodsmust "e restated as if the change #ere in effect during those periods$ andany cumulative effect from periods "efore those presented is anad+ustment to "eginning retained earnings of the earliest period presented

d Consistent use of accounting principles from one accounting period toanother enhances the usefulness of financial statements in comparativeanalysis of accounting data across time

e If a change in accounting principle occurs$ the nature and effect of a change inaccounting principle should "e disclosed to avoid misleading financial

statement users %here is a presumption that an accounting principle$ onceadopted$ should not "e changed in accounting for events and transactions of a similar type

f 1andatory accounting changes are largely non(discretionary %hus$managerial discretion is not present$ or at least is to a lesser degree Oneshould examine the motivations for voluntary accounting changes and assessany earnings *uality impact

g 1andatory accounting changes are largely non(discretionary >o#ever$ thereis often a #indo# of time for a company to adopt a mandatory accountingchange If a #indo# exists$ management has discretion as to the timing of theadoption %hus$ the timing of adoption and any accounting ramificationsshould "e considered ,or example$ if a manager is going to adopt anaccounting change that includes a large charge$ the manager might choose toadopt in a relatively poor *uarter to attempt to potentially conceal or do#nplaythe poor operating performance

6-21




Exercise 6(=Mconcluded

h 1andatory accounting changes often include the recognition of retroactiveearnings affects ,or example$ the rules in accounting for other post(employment "enefits re*uire that companies esta"lish a lia"ility for theaccrued "enefits to date %his results in a large charge for many companiesOf course$ the mar.et potentially vie#s the charge as largely the fault of accounting rule ma.ers %hus$ managers have incentive to increase theamount of the charge and use the "loated lia"ility to increase future earnings

Exercise 6(? &;G minutes'

Comprehensive income computationP

a Computation " 5alance sheet accounts affected

:$GGG$GGG !et income &closed to e*uity'( :GG$GGG /nrealized holding loss on availa"le for sale securitiesL @G$GGG ,oreign currency translation gain( ;@$GGG Additional minimum pension lia"ility ad+ustment( :;$GGG /nrealized holding losses on derivative instruments

:=$GGG Comprehensive income &component of e*uity'

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

6-22




Exercise 6(@ &=G minutes'

a %he point of sale is the most #idely used "asis for the timing of revenuerecognition "ecause in most cases it provides the degree of o"+ectiveevidence many consider necessary to measure relia"ly periodic "usinessincome %hat is$ sales transactions #ith outsiders represent the point in therevenue generating process #hen most of the uncertainty a"out the finaloutcome of "usiness activity has "een alleviated It is also at the point of salein 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 toproduce a relia"le statement of a firmKs effort and accomplishment for theperiod Any attempt to measure "usiness income prior to the point of sale#ould$ in the vast ma+ority of cases$ introduce considera"ly more su"+ectivityinto financial reporting than most accountants are #illing to accept

" : %hough it is recognized that revenue is earned throughout the entireproduction 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"le criteria for consistently and o"+ectively arriving at a periodicdetermination of the amount of revenue to ta.e up Also$ in most situationsthe sale is the most important single step in the earning process -rior tothe sale the amount of revenue anticipated from the processes of production is merely prospective revenueF its realization remains to "evalidated "y actual sales %he accumulation of costs during productiondoes not alone generate revenueF rather$ revenues are earned "y the entireprocess including the actual sales %hus$ as a general rule the sale cannot"e regarded as "eing an unduly conservative "asis for the timing of revenue recognition Except in unusual circumstances$ revenue

recognition prior to sale #ould "e anticipatory in nature and unverifia"le inamount

; %o criticize the sales "asis as not "eing sufficiently conservative "ecauseaccounts receiva"le do not represent disposa"le funds$ it is necessary toassume that collection of receiva"les is the decisive step in the earningprocess and that periodic revenue measurement and$ therefore$ net incomeshould depend on the amount of cash generated during the period %hisassumption disregards the fact that the sale usually represents thedecisive factor in the earning process and su"stitutes for it theadministrative function of managing and collecting receiva"les %hat is$ theinvestment of funds in receiva"les should "e regarded as a policydesigned to increase total revenues$ properly recognized at the point of saleF and the cost of managing receiva"les &eg$ "ad de"ts and collectioncosts' should "e matched #ith the sales in the proper period %he fact thatsome 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*uentto the sale does not detract from the overall usefulness of the sales "asisfor the timing of revenue recognition 5oth can "e estimated #ith sufficientaccuracy so as not to detract from the relia"ility

6-23




Exercise 6(@Mconcluded

of reported net income %hus$ in the vast ma+ority of cases for #hich thesales "asis is used$ estimating errors$ though unavoida"le$ #ill "e tooimmaterial in amount to #arrant deferring revenue recognition to a later point in time

c : $uring production %his "asis of recognizing revenue is fre*uently used "ycompanies #hose ma+or source of revenue are long(term constructionpro+ects ,or these companies the point of sale is far less significant to theearning process than is production activity "ecause the sale is assuredunder the contract$ except of course #here performance is notsu"stantially in accordance #ith the contract terms %o defer revenuerecognition until the completion of long(term construction pro+ects couldimpair significantly the usefulness of the intervening annual financialstatements "ecause the volume of completed contracts during a period isli.ely to "ear no relationship to production volume 2uring each year that a

pro+ect is in process a portion of the contract price is thereforeappropriately recognized as that yearKs revenue %he amount of thecontract price to "e recognized should "e proportionate to the yearKsproduction progress on the pro+ect It should "e noted that the use of theproduction "asis in lieu of the sales "asis for the timing of revenuerecognition is +ustifia"le only #hen total profit or loss on the contracts can"e estimated #ith reasona"le accuracy and its ultimate realization isreasona"ly assured

; /hen cash is received %he most common application of this "asis for thetiming of revenue recognition is in connection #ith installment sales

contracts Its use is +ustified on the grounds that$ due to the length of thecollection period$ increased ris.s of default$ and higher collection costs$there is too much uncertainty to #arrant revenue recognition until cash isreceived %he mere fact that sales are made on an installment contract"asis does not +ustify using the cash receipts "asis of revenue recognition%he +ustification for this departure from the sales depends essentially uponan a"sence of a reasona"ly o"+ective "asis for estimating the amount of collection costs and "ad de"ts that #ill "e incurred in later periods If these expenses can "e estimated #ith reasona"le accuracy$ the sales"asis should "e used

&AIC-A Adapted'

6-24




Exercise 6(6 &;@ minutes'

a 1ichael Company should recognize revenue as it performs the #or. on thecontract &the percentage(of(completion method' given that the right torevenue is esta"lished and collecti"ility is reasona"ly assured ,urthermore$the use of the percentage(of(completion method avoids distortion of incomefrom period to period$ and it provides for "etter matching of revenues #ith therelated expenses

" -rogress "illings #ould "e accounted for "y increasing Accounts Receiva"leand increasing -rogress 5illings on Contract$ a contra asset account that isoffset against the Construction Costs in -rogress account If the ConstructionCosts in -rogress account exceeds the -rogress 5illings on Contractaccount$ 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 theConstruction Costs in -rogress account$ the t#o accounts #ould "e sho#n$ inmost cases$ in the current lia"ilities section of the "alance sheet

c %he income recognized in the second year of the four(year contract #ould "edetermined as follo#s

• ,irst$ the estimated total income from the contract #ould "e determined "ydeducting the estimated total costs of the contract &the actual costs to dateplus the estimated cost to complete' from the contract price

• 3econd$ the actual costs to date #ould "e divided "y the estimated totalcosts of the contract to arrive at a percentage completed$ #hich #ould "emultiplied "y the estimated total income from the contract to arrive at thetotal 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 thecontract from the total income recognized to date

d Earnings in the second year of the four(year contract #ould "e higher usingthe percentage(of(completion method instead of the completed(contractmethod %his is "ecause income #ould "e recognized in the second year of the contract using the percentage(of(completion method$ #hereas no income#ould "e recognized in the second year of the contract using thecompleted(contract method

6-25




Exercise 6( &:@ minutes'

a Crime ControlKs revenue recognition practices$ #hile not the mostconservative$ conform to 4AA- %he important issue is #hether lessees #ill$ infact$ continue for their eight(year terms 3hould large cancellations occur$su"stantial portions of the revenue recognized in earlier years might have to"e reversed in su"se*uent years %his #ould result in distortions of earningpo#er and earning trends %hus$ a critical issue of this accounting is #hether the company provides ade*uately for contingencies such as cancellations3hould the pace of ne#ly #ritten sales(type leases slo#$ the companyKsearnings gro#th may stop or earnings may even decline

" While the tax accounting does provide the company #ith significant fundsfrom tax postponement$ it does not affect reported results "ecause under 4AA- the company is re*uired to provide for deferred taxes #hich it isassumed #ill "e paya"le in the future

c While it is true that the sale of the receiva"les #ithout recourse #ould ena"lethe 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 revenue recognition issue stirs controversy 1any "elieve that it isreasona"le for "oth companies to record offsetting advertising revenues andadvertising expenses from this contract %his is +ustified in that the

transaction seemingly meets the usual revenue recognition criteriaOpponents of this treatment #orry a"out uncertainty and completeness of theearning process

" Revenues and revenue gro#th are considered good indicators of futureprospects for 2otCom &Internet' companies Accordingly$ Internet companies#ant to maximize the amount of reported revenuesF even if those revenues areentirely offset #ith expenses

c An analyst should see. to determine the percent of revenues that come fromadvertising in such "arter transactions versus revenues from cash(paying &or credit' customers 3ome "elieve that "arter("ased revenues should "esegregated and vie#ed in a different light from that of more normal revenues%his might affect revenue multiples in determining stoc. price or decisions inother applications that rely on financial statements Analysts should ad+usttheir models according to their "eliefs a"out the relative merits of suchrevenues

6-26

http://www.dot.com/

http://www.dot.com/




Exercise 6( &=G minutes'

a 3ome costs are recognized as expenses on the "asis of a presumed directassociation #ith specific revenue %his has "een identified "oth as)associating cause and effect) and as the )matching concept) 2irectcause(and(effect relations can seldom "e conclusively demonstrated$ "utmany costs appear to "e related to particular revenue$ and recognizing themas expenses accompanies recognition of the revenue 4enerally$ the matchingconcept re*uires that the revenue recognized and the expenses incurred toproduce the revenue "e given concurrent periodic recognition in theaccounting records Only if effort is properly related to accomplishment #illthe results$ called earnings$ have useful significance concerning the efficientutilization of "usiness resources %hus$ applying the matching principlerecognizes the cause(and(effect relationship that exists "et#een expense andrevenue Examples of expenses that are usually recognized "y associatingcause and effect are sales commissions$ freight(out on merchandise sold$ andcost of goods sold or services provided

" 3ome costs are assigned as expenses to the current accounting period"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 "eincurred each accounting year$ and no "uildup of expected future "enefitsoccursF &?' "y their nature they relate to current revenues even though theycannot "e directly associated #ith any specific revenuesF &@' the amount of cost to "e deferred can "e measured only in an ar"itrary manner or greatuncertainty exists regarding the realization of future "enefits$ or "othF and &6'uncertainty exists regarding #hether allocating them to current and future

periods #ill serve any useful purpose %hus$ many costs are called )periodcosts) and are treated as expenses in the period incurred "ecause neither dothey 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 periodin #hich they are paid or accrued for payment Examples of costs treated asperiod expenses #ould include officersK salaries$ advertising$ research anddevelopment$ and auditorsK fees

c A cost should "e capitalized$ that is$ treated as an asset$ #hen it is expectedthat the asset #ill produce "enefits in future periods %he important concepthere is that the incurrence of the cost has resulted in the ac*uisition of anasset$ a future service potential If a cost is incurred that resulted in theac*uisition of an asset from #hich "enefits are not expected "eyond thecurrent period$ the cost may "e expensed as a measure of the servicepotential that expired in producing the current periodKs revenues !ot onlyshould 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 a reasona"le degree of o"+ectivity$ and there should "e reasona"legrounds for associating it #ith the asset ac*uired Examples of costs thatshould "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 coveragerelating to future periods$ and the costs of self(constructed plant or e*uipment

d In the a"sence of a direct "asis for associating asset cost #ith revenue$ and if

the asset provides "enefits for t#o or more accounting periods$ its costshould "e allocated to these periods &as an expense' in a systematic andrational manner When it is impractical$ or impossi"le$ to find a closecause(and(effect relationship "et#een revenue and cost$ this relationship isoften assumed to exist %herefore$ the asset cost is allocated to theaccounting periods "y some method %he allocation method used shouldappear reasona"le to an un"iased o"server and should "e follo#edconsistently from period to period Examples of systematic and rationalallocation of asset cost #ould include depreciation of fixed assets$amortization of intangi"les$ and allocation of rent and insurance

e A cost should "e treated as a loss #hen an unfavora"le event results from anactivity other than a normal "usiness activity %he matching of losses tospecific revenue should not "e attempted "ecause$ "y definition$ they areexpired service potentials not related to revenue produced %hat is$ lossesresulting from extraneous and exogenous events that are not recurring or anticipated as necessary in the process of producing revenue %here is nosimple #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 anasset$ expense$ loss$ and prior(period ad+ustment is not clear(cut ,or 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 potentialexpired that is considered a"normal$ unnecessary$ unanticipated$ andpossi"ly nonrecurring and is usually not ta.en into direct consideration inplanning the size of the revenue stream

&AIC-A Adapted'

Exercise 6(:G &:@ minutes'

a Research and development costs are expensed in the year that they areincurred %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 indetermining future income

" RN2 expenditures at ,rontier 5iotech decreased su"stantially in fiscal ;GG6As a result$ fiscal ;GG6 net income is su"stantially higher >o#ever$ this maynot "e a good signal for future profita"ility %o the extent that one hasconfidence in the a"ility of the RN2 department at ,rontier 5iotech$ futurerevenues may "e compromised "y management<s decision to curtail researchefforts

6-28




Exercise 6(:: &:@ minutes'

a %heoretically$ presentation in the "ody of the statement or in the footnotesshould have no influence on the analysis of the financial statements Inpractice$ ho#ever$ footnote disclosures are typically insufficient In addition$information is more difficult to overloo. #hen presented in the "ody of thefinancial statements

" An analyst #ould ad+ust the analysis of financial statements "y recastingexpenses and income computations to include the disclosed stoc. optionexpense In addition$ the analyst #ould recast retained earnings to reflect thestoc. option expense &net of tax'

c !umerous ratios are affected "y the accrual versus non(accrual of compensation expense related to employee stoc. options ,or example$ allratios 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 plan #ill "e deemed to "e compensatory %his is "ecause the stoc.option plan is only offered to certain employees and the life of the option isnot short

" IncentCom #ould offer such a lucrative plan to its employees to attract andretain a talented #or. force >uman capital is a .ey asset in technologycompanies

c %he grant date is 8anuary :$ ;GG?F Vesting date is 8anuary :$ ;GGF ,irstexercise date is 8anuary :$ ;GG

d !o$ the employee stoc. options are not in(the(moneyB at the grant date %hisis "ecause at the grant date the exercise price is greater than or e*ual to &notless than' the mar.et price of the stoc.

e %otal compensation cost should "e measured at the date of measurement%he date of measurement is the earliest date that the num"er of shares andthe stoc. option price is .no#nM#hich is 8anuary :$ ;GG?$ in this case

6-29

http://www.incent.com/

http://www.incent.com/




Exercise 6(:;Mconcluded

f %otal compensation cost to "e recognized #ill depend upon the accountingrules applied /nder APB $ total compensation cost is GF computed as theintrinsic value of the options times the num"er of shares$ or Q&;G;G' x:GG$GGG sharesS /nder S&AS .3$ the D:$@=D options &rounded up' areexpected to vest "ased on the ?T forfeiture rate 3pecifically$ :GG$GGG x ?T J?$GGG options in ;GGGF 6$GGG x ?T J =$D?G options in ;GG:F ;$: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@;$=G? in total compensation expenseshould "e recognized &D:$@=D options x D fair value per option'

g Compensation cost should "e allocated over the service period$ years ;GG?through ;GGD

h %he employee stoc. option plan transfers #ealth from stoc.holders toemployees "y granting potential o#nership rights to employees #ith less than

full "uy(inB to ac*uire these o#nership rights %hat is$ if existing o#nership#ere diluted via a normal issuance of shares to investors$ contri"uted capitalreceived from the investors #ould "e much greater than that received from theexercise price of stoc. options

Exercise 6(:= &:@ minutes'

a 1anagers often hold$ or expect to hold$ stoc. options As a result$ they #illincrease their #ealth #hen the mar.et price of the stoc. increasing exceeds

the exercise price of stoc. options they hold 5y #ithholding good ne#s andselectively releasing "ad ne#s "efore the date that the option<s exercise priceis esta"lished$ the managers allegedly depress the price of the stoc. &at leasttemporarily' until the exercise price is esta"lished

" In the analysis of company performance and stoc. valuation$ silence "efore agrant date might "e interpreted as a sign that no significant "ad ne#s is.no#n "y the managers &given their incentive to release "ad ne#s prior to thedate to esta"lish an exercise price #hen managers hold stoc. options'1oreover$ an analyst might expect that good ne#s #ould "e #ithheld "ymanagers until after the date that the exercise price of the stoc. options isesta"lished

6-30




Exercise 6(:? &;G minutes'

a 3ome transactions affect the determination of net income for accountingpurposes in one reporting period and the computation of taxa"le income andincome taxes paya"le in a different reporting period In accordance #ith thematching principle$ the appropriate income tax expense represents theincome tax conse*uences of revenues and expenses recognized for accounting purposes in the current period$ #hether those income taxes arepaid or paya"le in current$ future$ or past periods Accordingly$ a deferredincome taxes account is setup to reflect such timing differences

" When depreciation expense for machinery purchased this year is reportedusing the 1ACR3 for income tax purposes and the straight(line "asis for accounting purposes$ a timing difference arises 5ecause more depreciationexpense is reported for income tax purposes than for accounting purposesthis year$ pretax accounting income is more than taxa"le income %hedifference 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 yearKstaxa"le income "ut as unearned revenues &a current lia"ility' for accountingpurposes$ a timing difference arises 5ecause rent revenues are reported thisyear for income tax purposes "ut not for accounting purposes$ pretaxaccounting income is less than taxa"le income %he difference creates a de"itto deferred income taxes e*ual to the difference in rent revenues multiplied "ythe appropriate income tax rate

c %he income tax effect of the depreciation &timing difference' is classified on

the "alance sheet as a noncurrent lia"ility "ecause the asset to #hich it isrelated is noncurrent %he income tax effect of the rent revenues received inadvance &timing difference' is classified on the "alance sheet as a currentasset "ecause the lia"ility to #hich it is related is current %he noncurrentlia"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 &timingdifference' and the rent revenues received in advance &timing difference'should "e netted %his amount is classified as a deferred component of income tax expense

6-31




Exercise 6(:@ &:@ minutes'

%here are at least t#o earnings targets that are typically relevant for managersand investors %he first is the consensus earnings expectation of the analystcommunity %he second is the earnings in the same *uarter of the previous fiscalyear &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 sustainedprofit gro#th and s.illed leadership %his means that companies near thesetargets #ill use earnings management to meet or exceed these targets$ even if only "y a penny Accordingly$ earnings increases of GG: can "e significant#hen the change pushes earnings e*ual to or a"ove relevant earnings targetsOf course$ a magnitude or scale issue can "e relevant as #ell A GG: change inan earnings per share figure that is approximately GG@ per share in total can "e*uite relevant$ #hereas a GG: change for an earnings per share figure that isapproximately :GGG per share can "e su"stantially less relevant

Exercise 6(:6 &;G minutes'

a %he effects of dilutive stoc. options and #arrants are not included in thecomputation of the num"er of shares for "asic earnings per share %hey are$ho#ever$ included in diluted earnings per share computations

" %he effects of dilutive converti"le securities are not included in thecomputation of the num"er of shares for "asic earnings per share %hey are$ho#ever$ included in diluted earnings per share computations

c Antidilutive securities are excluded from "oth "asic and diluted earnings per share

6-32




Exercise 6(: &;G minutes'

a 5asic earnings per share is the amount of earnings attri"uta"le to commonshareholders &that is$ net income less preferred dividends' divided "y the#eighted average num"er of common shares outstanding for that period

" 2iluted earnings per share is the amount of current earnings per share thatreflects the maximum dilution that #ould result from the conversion of allconverti"le securities and the exercise of all #arrants and options %heconversion of these securities individually #ould decrease earnings per shareand in the aggregate #ould have a dilutive effect %he computation of dilutedearnings per share should "e "ased upon the assumption that all such issuedand issua"le shares are outstanding from the "eginning of the period$ or fromtheir inception if after the "eginning of the period %o summarize$ #hereas"asic earnings per share does not reflect any securities converti"le or exercisa"le into common shares$ diluted earnings per share includes all suchsecurities and considers their dilutive effect upon earnings per share$ ta.ing

into account necessary ad+ustments to income resulting from the conversionprocess

&C,A Adapted'

Exercise 6(:D &:@ minutes'

: " 3hares outstanding after the stoc. dividend are ; million sharesoutstanding entire year L :GT of ; million shares outstanding for H:; of year$OR ; mill L ; mill&@' J ;$:@G$GGG shares

; a &potentially dilutive securities are not considered in "asic earnings per

share'= a &#arrants are antidilutive "ecause more shares are assumed "ought "ac. atthe 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 D 7ear

3ales @ 6GGCosts and expenses &6@' &@6'-retax income ::D ;?

%ax expense &@' &:;'Income from continuing operations @ :;2iscontinued operations

Operations &net of tax' QaS &=' D2isposal &net of 6 tax' Q"S &6'

!et Income @G ;G

QaS Represents net income &loss' from operations for 7ear and for 7ear D untilAugust :@

Q"S Represents0oss from operations August :@ to 2ecem"er =: &:'0oss on sale of assets &after @ tax' &@'%otal &6 '

%he :G loss and related tax "enefit of @ #ould still "e recorded &anticipated' at2ecem"er =:$ 7ear D &the asset #ould "e reduced "y :G to mar.et value'

-ro"lem 6(; &=G minutes'

: a

; " &?GT of revenues and costs are recognized'

= a

? d

@ a

6 c

d Q&:;G$GGGH=GT' L &??G$GGGH?GT'S

6-34




-ro"lem 6(= &;@ minutes'

a &:' &ailing to timely record returned credit card purchases and membershipcancellations An accounts receiva"le analysis #ould "e the focal point toidentifying this pro"lem We #ould examine for either continual gro#th inaccounts receiva"le or unusual &unexplained' #rite(offs of receiva"lesRatios or techni*ues that compare cash collections to accounts receiva"lealso could potentially identify a pro"lem area or fraudulent "ehavior

&;' %mproperly capitali1ing and amorti1ing expenses related to attracting new members %his "ehavior #ould "e difficult to uncover %he .ey is tounderstand the gro#th in reported intangi"le assets and deferred charges$and to assess its reasona"leness /nusual increases should "e vie#ed asa potential red flag

&=' -ecording fictitious sales One .ey to uncovering fictitious sales is tomonitor the +oint "ehavior of sales and accounts receiva"le$

simultaneously Increasing sales should not necessarily lead to slo#er accounts receiva"le turnover Increases in the accounts receiva"leturnover ratio should "e investigated "ecause this can "e caused "y$among other factors$ the recognition of fictitious or uncollecti"le sales

" %he external auditor must conduct the audit according to generally acceptedauditing standards %he culpa"ility of auditors in a fraud situation varies on acase "y case "asis It is often difficult to detect a fraud if .ey client personnelare colluding and conspiring to cover up >o#ever$ in this case the fraud #asso #idespread that auditor negligence is part of the pro"lem ,rom an

economic perspective$ this *uestion #ill ultimately "e ans#ered via litigation

6-35




-ro"lem 6(? &?@ minutes'

a Estimation of 2epreciation on %ax Returns.. .0 +

2i 2epreciation expense Q:6;AS :?@ :D?: :@

2ii 2epreciation timing difference Q:;DS @ :D6 ::

2iii Excess depreciation &divide tax difference"y statutory tax rate 42ii53(67 :? @? =@G

2epreciation on tax return 42i82iii ' 7 ;:: ;=D D ;:G

" Identification of Amounts N 3ources &com"ining federal$ state and foreign taxes'.. .0 +

: Earnings "efore income taxes Q;6S 66? :? :G6@

; Expected income tax U =?T &confirmed "y Q:=?S' ;;6 6:G =6;= %otal income tax expense Q;S ;6@ :@G =?? %otal income tax due P ;=G? ::: :6:;@ %otal income tax due and not yet paid Q??S 6 ?6? =G:

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

c 2ifferences "et#een Effective %ax Rate and 3tatutory Rate &=?T'P.. 6 .0 6 + 6

Q:=?S %ax at statutory rate;;6 =?G=?G =6;=?GQ:=@S 3tate tax &net of fed "enefit' ;GG =G= =D=6Q:=6S !ondeducti"le divestitures$ re(

structuring and unusual charges M M :G:? @6@ @: ?DQ:=S !ondeducti"le amortization of

intangi"les ?G G6 :6 G :; ::Q:=DS ,oreign earnings not taxed or taxed

at other than statutory rate &;G' &G=' ;; :; G; G;Q:=S Other :6 ; @ ; ; : ; G : G :

%otals;6@ 6 = D :@ G @ = ? D

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

d Camp"ell can pro"a"ly deduct for tax purposes only cash actually spent in 7ear :G for these charges If this is so$ an estimate of cash spent is &see itemQ: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$am "ear . "ear "ear 3 "ear ( "ear 9otal

5oo. income : ;?$GGG ;$GGG ;?$GGG :;G$GGG

5oo. income ; =$DGG @$6GG :;$6GG :;6$GGG

5oo. income = :@$GGG ?@$GGG @$GGG :@$GGG :@G$GGG

a %otal "oo. income ;?$GGG :;?$DGG :??$6GG D$6GG :@$GGG =6$GGG

%axa"le income : :;G$GGG :;G$GGG

%axa"le income ; :;6$GGG :;6$GGG

%axa"le income = :@G$GGG :@G$GGG

" %otal taxa"le Inc :;G$GGG :;6$GGG :@G$GGG =6$GGG

0ine ? less 0ine D ;?$GGG :;?$DGG ;?$6GG &=D$?GG ' &:=@$GGG '

c Incr in def tax &cr' :;$GGG 6;$?GG :;$=GG

2ecr in def tax &dr' :$;GG 6$@GG

6-37




-ro"lem 6(6 &?@ minutes'

3%EA2 COR-ORA%IO!

& in thousands' 7ear ? 7ear @ 7ear 6

a Income 3tatement

3ales :G$GGG :G$GGG :G$GGG

Expenses P $GGG $GGG :G$?GG

Income "efore tax :$GGG :$GGG &?GG'

%ax expense

Current PP M =GG @GG

2eferred @GG ;GG &GG'

%otal tax expense @GG @GG &;GG'

!et income &loss' @GG @GG &;GG'

P Includes unusual expense of :$?GG in 7ear 6PP%axa"le income &loss'

5efore loss carryfor#ard &?GG' :$GGG :$GGGAfter deducting loss carryfor#ard M 6GG M%ax due &at @GT' M =GG @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 &theremaining ?GG "ecomes a loss carryfor#ard and reduces taxa"le income in 7ear @' %hetax effect &at @G percent' of these differences is @GG in 7ear ? and ;GG in 7ear @ %heentire timing difference reverses in 7ear 6

" 5alance 3heet

Current tax paya"le M =GG @GG

2eferred tax paya"le @GG GG M

6-38




-ro"lem 6( &6G minutes'

Income 3tatement

7ears : ; = ? @ 6 D

3ales @G DG :;G :GG ;GG ?GG @GG 6GG

Cost of sales ;G =G @G =GG @G :;G ;GG ;@G

4eneral and administrative :G :@ ;G :GG ;G =G ?G @G

!et income "efore tax ;G =@ @G &=GG' :=G ;@G ;6G =GG

%ax expense &refund'P

Current provision :G :@ ;@ ;@ :=G :@G

Refund from carry"ac. &@;@'

%ax effect of loss carryfor#ard 6@ =; @

%otal tax expense :G : @ ;@ &@; @' 6@ :;@ :=G :@G

Income "efore extraordinary items :G :@ ;@ &;?@' 6@ :;@ :=G :@G

Extraordinary gain &reduction' of taxes due to carryfor#ard 6@ =; @

!et income &PP' :G : @ ;@ &;? @' :=G :@ @ :=G :@G

P %axa"le income ;G =@ @G &=GG' &6@'" :D@c ;6G =GG%ax due at @GT rate :G :@ ;@ &@;@'a G ;@ :=G :@G

aOperating 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 :@cIncome 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 $r; 2<r;7 %ax expense :G :@ ;@ &@;@' 6@ :;@ :=G :@G,I% Receiva"le @;@

,I% -aya"le &:G' &:@' &;@' &;@' &:=G' &:@G'Extraordinary gains &6@' &=;@'

6-39




-ro"lem 6(D &=G minutes'

: c &6$@GG$GGG net income H ;$@GG$GGG shares J ;6G'; "

2iluted E-3 J Ad+usted net income#td avg of L #td avg num"er common stoc. of common sharesoutstanding issua"le from options

and converti"les

3ince average mar.et price of stoc. exceeds exercise price of options$ theoptions are dilutive /sing treasury stoc. method for options #e o"taini ;GG$GGG shares :@ J =$GGG$GGG proceedsii =$GGG$GGG H ;G average price J :@G$GGG shares purchased in open mar.et%hus$ @G$GGG additional shares #ould "e issued

Are the converti"le "onds dilutive !o Assuming conversion of "onds$ :GG$GGGadditional shares #ould "e issued %he net income ad+ustment #ould "e

Interest expense related to "onds @GG$GGG0ess taxes &;GG$GGG'Increase in net income =GG$GGG

Conse*uentlyE-3 J &6$@GG$GGGL=GG$GGG'H&;$@GG$GGGL:GG$GGG' J ;6;2iluted E-3 J 6$@GG$GGGH&;$@GG$GGGL@G$GGG' J ;@@

-ro"lem 6( &?G minutes'a 5asic E-3 Computations

5asic E-3 J ?$GGG$GGG H =$GGG$GGG shares J :==

2iluted E-3 Computations3ince average mar.et price of stoc. exceeds exercise price of options and#arrants$ the options and #arrants are dilutive /sing treasury stoc. methodi :$GGG$GGG shares :@ J :@$GGG$GGG proceedsii :@$GGG$GGG H ;G J @G$GGG shares purchased in open mar.et%hus$ ;@G$GGG additional shares #ould "e issued2iluted E-3 J ?$GGG$GGG H =$;@G$GGG shares J :;=

" 5asic E-3 Computations5asic E-3 J =$GGG$GGG H =$GGG$GGG shares J :GG

2iluted E-3 Computations3ince average mar.et price of stoc. exceeds exercise price of options and#arrants$ the options and #arrants are dilutive /sing treasury stoc. methodi :$GGG$GGG shares :@ J :@$GGG$GGG proceedsii :@$GGG$GGG H :D J D==$=== shares purchased in open mar.et%hus$ :66$66 additional shares #ould "e issued2iluted E-3 J =$GGG$GGG H =$:66$66 shares J G@

6-40




CA3E3

Case 6(: &@G minutes'

a 5alance 3heets and Income 3tatements #ith Alternative Revenue Recognition

3hipment Collection -roduction "

5alance 3heetCash :$6G :$6G :$6G :$6G

Receiva"les :$DGG :$DGG :$DGG :$DGG

Inventory$ at cost GG GG (( ((

Inventory$ at mar.et ( ( ( ( GG Gc

%otal assets ?$:G ?$:G ?$=G ?$;6G

Accrued shipping cost (( (( ;G ((Accrued sales commission :DG :DG ;G :DG

2eferred income (( :DGa (( ((

Invested capital =$GGG =$GGG =$GGG =$GGG

Retained earnings G D:G :$GDG :$GDG

%otal lia"ilities and e*uity ?$:G ?$:G ?$=G ?$;6G

Income 3tatement

3ales$GG D$:GG :G$DGG $GGCosts and expenses

Cost of goods sold $GG 6$=GG D$?GG $6:Gd

3elling expense G D:G :$GDG G

3hipping expense ;;G :DG ;?G ;;G

!et income G D:G :$GDG :$GDG

*otesa 2eferred income 3ales is :$DGG less costs of &:$?GG L :DG L ?G' J :DG" %ime of production ,igures can "e reflected gross as in left column or net as in right

column

c Inventory$ at net realiza"le value G J GG less ;G less Gd Cost of goods sold is a )to("alance) figure "ased on inventory &for example$ 5eg G plus

purchases D$?GG less End G J CO43 $6:G'

6-41




Case 6(:Mcontinued

" %he installment method delays the reporting of revenues and there"y delaysthe time for payment of taxes %he time value of money is a ma+or motivationfor delaying cash payments for taxes

c 5alance 3heet 3ome analysts prefer the installment method "ecause it ismore conservative >o#ever$ the installment method attempts to valuereceiva"les &less deferred income' at the historical cost of the inventory It#ould appear that the credit analyst should "e future(oriented and vie#receiva"les at the expected future cash inflo#

Income 3tatement 3ome analysts prefer the installment method "ecause it ismore conservative >o#ever$ this method has t#o critical #ea.nesses&i' Revenues and profits are not recognized #hen performance &earning'

occursF instead$ recognition is delayed until cash is collected

&ii' 3elling costs are mismatched &this is most dramatic in a period of rapidgro#th or decline in sales'

%he installment method does not sho# economic reality

6-42




Case 6(; &6G minutes'

a Computation of earnings components as a percent of sales 7ear :: 7ear :G 7ear

3ales :GGT :GGT :GGT

Cost of products sold 66GT 6D6T G@T

1ar.eting and selling expenses :@?T :@DT :??T

Administrative expenses ?T ?T ??T

Research and development expenses GT GT GDT

Interest expense :T :DT :T

Interest income (G?T (G=T (GT

,oreign exchange losses$ net GGT G:T G=TOther expense G?T G;T G6T

2ivestitures$ restructuring and unusual charges GGT @@T 6GT

Cost of products &goods' sold has declined in each of the = years as apercentage of sales %his has accounted for most of the change in pre(taxprofits as all other expense categories have remained fairly constant asidefrom restructuring costs$ #hich #ere not present in 7ear ::

" 3ales and cost of goods sold are typically the most highly persistent$ andreductions on CO43 as a percentage of sales such as #e see in this exampleare rare 34NA costs are also typically highly persistent >o#ever$ thecompany may "e a"le to find #ays to cut some of these through operatingefficiencies %he RN2 costs are also reasona"ly persistent Again$ thecompany can choose to increase or decrease these$ "ut such a decision canhave severe ramifications for future profita"ility Restructuring costs aregenerally vie#ed as transitory

c -rovision for taxes as a percent of earnings "efore income taxes 7ear :: J ;6@H66? J =DT 7ear :G J :@GH:? J @T

7ear J =?H:G6@ J DT

2eviations from the statutory percentage of =@T commonly arise as a result of expenses that are recognized for financial reporting purposes that are notdeducti"le for tax purposes An example is a restructuring charge that must"e recognized #hen incurred for financial reporting purposes$ "ut cannot "ededucted for tax purposes until paid

6-43




Case 6(;Mconcluded

d Camp"ell reports ==: million and =?=G million in divestitures$restructuring and unusual charges in 7ears :G and $ respectivelyRestructuring costs typically include asset #rite(do#ns and severance costsAsset #rite(do#ns are non(cash charges that typically relate to reduced cashflo#s of those assets that li.ely have occurred over several prior years3everance costs typically relate to accruals of costs that #ill not "e paid untilsome future period

e Removal of costs relating to deprecia"le assets #ill reduce futuredepreciation expense A cost is$ therefore$ recognized in the current periodthat #ould have "een recognized in future periods$ thus shifting income fromthe present into the future 3imilarly$ severance costs include the accrual of alia"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

2escriptionClassific

ation

Charge

/tilized-re(%ax

5alance-re(%ax

-re(%ax

-ost(%ax

0ease CommitmentsRestruc D: G D:

3everanceHClosing CostsRestruc ; ? ;@

--NE Write(2o#nRestruc :@@ :@@ G

OtherRestruc ; @ ;?

%otal Restructuring ;? ;66 :6? :=G

Change in acctg estimateHlegalprovision

34NA = =

=rd party claimsH,%C34NA ;G := ;G

%O%A0 =@= ; :D? :6

1ar.do#n(Clear Excess InventoryC43 ;@= : ?

1ar.do#n(3tore Closedo#nsC43 ; ; ;

Inventory 3ystems RefineHChangein estimates

C43 6= @ 6

%O%A0 =?@ ;; ;=D :G

4RA!2 %O%A0 6D @GD ?;; ;6

6-45




Case 6(=Mcontinued

;

RECA3% I!CO1E 3%A%E1E!% A,%ER RE1OVI!4 C>AR4E

: :DReported Recast Reported

T T T

!et 3ales:::G :GGT :::G :GGT ::G=D :GGT

Cost of goods soldD:: ==T D?6 G;T :G 6DT

4ross -rofit; ;6T ==;? ;DT ==;D =G;T

3elling$ general N administrative;??= ;:T ;=D? ;:=T ;;=: ;G;T

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

Restructuring Charge;? ;6T G GGT G GGT

Interest Expense less Income= GDT = GDT ; GT

Earnings "efore tax&:G6' (GT @; @=T ; GT

%ax -rovision;6 G;T ;:6 :T ;D; ;6T

Earnings after tax&:=;' (:;T =6 =?T ?G ??T

%otal Charge @GD ?@T

EA% after charge&:=;' (:;T &:=;' (:;T ?G ??T

Cost of goods sold is increasing$ resulting in decreasing gross profit 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 marginon sales

6-46




Case 6(=Mcontinued

=Elements of Restructuring -lan and Expected Economic Effects

Element 2escription Cost Expected EconomicEffects3toreClosing

- Close @Ginternational and %oys RB /sstores that donot meetstrategicprofita"ilityo"+ectives

- Close =: /3Xids RB /s

stores andconvert ;Dnear"y %oys RB/s stores intocom"o stores

0eases D:3everance etc ;--E Write do#n :@@1ar.do#n ;Acctg change N legal settlements =%otal ===

3ales reduction =;;11$ operating losssaving @ 11 pa;6GG employeesterminated & :GG(:@G11 pa saving'

Closings Eliminateloss ma.ingstoresHfocus on moreprofita"le opportunitiesCom"o 3tores Release#or.ing capital$ lo#eroperating costs$increase productivity

C= -lan(3toreReformatting etc

- Reformat stores$expand productlines

- 3upply chainreengineering

1ar.do#n ;@=3ystems Refined 6=%otal =:6

@DG &;?T' reduction instores inventory

Enhanced customerexperience>igher

productivityHlo#erinventoryHlo#ercostHheightenedflexi"ility

Consolidation ofdistri"utioncentersand adminoffices

- Consolidatedistri"utioncentersH#arehouses

- Consolidate 6admin offices

Other ; Improve 34NAefficiencies,latten managementand increase customerresponsiveness

0egal

Contingencies

- ,%C related =rd

party claim

=rd party claims ;G

%O%A0 6D Expected savings 11 pa

6-47




Case 6(=Mcontinued

? %he restructuring lia"ility can "e purposefully overstated to create a hiddenreserve %his hidden reserve can "e used to manage earnings in at leastt#o #ays ,irst$ the company can charge some operating expenses of future periods to the restructuring lia"ility 3econd$ the company can

reverse a portion of the charge to create net income in the period of thereversal

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 earningsmanagementB &see Chapter ;' >o#ever$ "y "urying various elements of thecharge in different line items the very purpose of the charge$ ie$ inducingusers to ignore the entire charge is lost %herefore it is not li.ely that thepurpose of the restructuring charge #as earnings management

@ %he follo#ing ad+ustments #ould "e made to the financial statements torecast the restructuring charge as an investment to create future cost

savings ,irst$ the charge is recorded as an asset and amortized over :Gyears 3econd$ ;GxD income is increased "y reversing the charge Incomein fiscal ;Gx and the next :G years #ill then "e reduced "y a pro(rataamount of the investmentB

6 %he relative success of restructuring activities can and must "e assessed%he company should report higher return on assets and higher return one*uity Also$ the company should report su"stantially lo#er costs such asselling and administrative costs %hese costs should also decrease as apercentage of sales

Case 6(? &6G minutes'

a 5asic Earnings -er 3hare Computations5asic 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 shares x :G J $GGG$GGG proceedsii $GGG$GGG H := J 6;$=G shares purchased in open mar.et%hus$ ;G$6= additional shares #ould "e issued

As ifB E-3 J :$@GG$GGGH&GG$GGGL;G$6=' J :=@

Are the su"ordinated converti"le de"entures dilutive 7es Assumingconversion$ a total of @GG$GGG &$GGG$GGGH:D' additional common shares#ould "e issued at 8une =G$ 7ear : %he net income ad+ustment #ould "eInterest expense for de"entures ;G$GGG0ess taxes &:=@$GGG'Increase in net income :=@$GGG

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As ifB E-3 J &:$@GG$GGGL:=@$GGG'H&GG$GGGL;@G$GGG' J :?;Conse*uently2iluted E-3 J &:$@GG$GGGL:=@$GGG'H&GG$GGGL;G$6=L;@G$GGG' J :;G

" Interest expense &7ear ;'

2e"entures &$GGG$GGG x 6T' @?G$GGG%erm loan &=$GGG$GGG x T'H; :G@$GGG

&;$@GG$GGG x T'H; D$@GGInterest expense =;$@GG

Earnings "efore interest and taxes &7ear ;'!et income :$@GG$GGG%axes &@GT' :$@GG$GGGInterest expense @GG$GGGEarnings "efore interest and taxes =$GGG$GGG

%imes interest earned J =$@GG$GGGH=;$@GG J ?DCase 6(@ &?@ minutes'

I a 5asic E-3 J Q;D@$GGG( &;?G x :G$GGG shares'S H G$GGG shares J ;G

" 2iluted E-3Are the converti"le "onds dilutive 7es Assuming conversion$ the netincome ad+ustment #ould "e

Interest expense for de"entures DG$GGG0ess taxes &?G$GGG'Increase in net income ?G$GGG

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 Computation of 5asic Earnings -er 3hareWeighted average shares outstanding during 7ear 6

8anuary : :G$GGG sh : yr :G$GGG sh8uly : ;$GGG sh :H; yr :$GGG sh

::$GGG sh

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

Ch 06 - Analyzing Operating Activities

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Transcript of Ch 06 - Analyzing Operating Activities