ACC 3020 Final Exam

Error Affecting Previous Financial Statements, but Not Net Income could include

(1) recording a balance sheet item in the wrong account, (2) recording an income statement item in the wrong account without affecting net income, (3) classifying a cash flow incorrectly in the statement of cash flows; since these errors do not affect income, no prior period adjustment would be needed)

Errors

(Corrections of errors are not accounting changes but are accounting for similarly using the retrospective approach-see next section)

2. Adjust Accounts for the Change

(a journal entry needs to be made to adjust accounts to the correct balances reflecting the new principle as of the beginning of the year of the change)

Part B-Earnings Per Share

(a single number reported frequently to summarize a company's performance) Basic Earnings Per Share (all companies need to report basic EPS on the face of the income statement; basic EPS is based on what actually happened during the year and is calculated as income available to common shareholders divided by the weighted average number of common shares outstanding during the period)

2. Interest cost

(because the employer has an obligation that is not paid until retirement, the obligation is increased each year for the interest which accrues on the existing obligation)

Part A-Share-Based Compensation

(employee compensation plans often include share-based awards, forms of payment whose value is dependent on the value of the company's stock; the idea behind these plans is that if executives (and perhaps other employees) are compensated with share-based awards, they will work hard to drive up the value of the shares, thus making their compensation worth more; we will only look at stock options as one example (skipping restricted stock plans and stock appreciation rights plans); in addition, we will only look at a basic stock option plan and will not cover option plans with performance or market conditions)

Order of Entry for Multiple Convertible Securities

(for diluted EPS, we want the hypothetical worst case scenario or lowest possible EPS; if we assume the exercise or conversion of all potential common shares, this won't necessarily get us to the lowest possible number; instead, we first calculate the earnings per incremental share for each of the potential common shares; we then assume their exercise or conversion one at a time, starting with the item with the smallest earnings per incremental share (if dilutive), and continue to assume the exercise or conversion of other items with increasing earnings per incremental share, as long as they are still dilutive compared to the prior calculation; when we have included all potential common shares or the next item becomes antidilutive, the last calculation becomes the diluted EPS)

The Relationship between Pension Expense and Changes in the PBO and Plan Assets

(for our purposes, the two items that affect the PBO each year (service cost and interest cost) and the expected return on the plan assets are the three items that will be included in pension expense)

Expense-The Great Debate

(historical background on which we will not focus; led to current GAAP requirement of fair value accounting for employee stock options)

Issuance of New Shares

(if additional shares are issued during the year, these shares are included in the denominator, weighted for the fraction of the year they were outstanding)

When Unexercised Options Expire

(if options expire unexercised, the related amount in the Paid-in Capital-Stock Options account is reclassified to a Paid-in Capital-Expiration of Stock Options account)

Options, Warrants, Rights

(if the exercise price exceeds the average market price, it would be irrational to think that exercise would have taken place; in addition, using the treasury stock method would decrease the number of shares assumed outstanding which would be antidilutive) Convertible Securities (for convertible securities, the earnings per incremental share of any assumed conversion can be calculated by dividing the assumed change to the numerator by the assumed changed to the denominator; if the incremental effect is higher than basic EPS, that item is antidilutive and is not considered for diluted EPS)

1. Revise Comparative Financial Statements

(income statement: appropriate amounts in the income statement will be adjusted as if the new method had been used in those prior years; balance sheet: appropriate balances, including retained earnings, will be adjusted as if the new method had been used in those prior years; statement of shareholders' equity: the beginning retained earnings balance for the earliest period presented in the comparative statements must be adjusted for the cumulative effect of the change prior to that date)

1. Service Cost

(increases pension expense)

2. Interest Cost

(increases pension expense)

Error Affecting a Prior Year's Net Income

(most errors affect net income and therefore affect the balance sheet also; they may also affect the statement of cash flows; most errors that affect income will also have tax effects, either taxes payable or refundable or deferred tax assets or liabilities; we will mostly look at errors without their tax effects, but we need to realize that many error corrections will have tax consequences; the effect of an error and the necessary correction may depend on when the error is discovered; many errors self correct, at least over a period of years, sometimes within the next year; even if they self correct, errors may need correcting journal entries and/or restatement of prior years' numbers in comparative statements)

Pension Expense

(pension expense consists of five potential components, only three of which we will discuss: service cost, interest cost, and expected return on the plan assets; the other two-amortization of prior service cost and amortization of losses or gains-will not be discussed in this class)

The Nature of Pension Plans (pension plans are designed to provide income to individuals during their retirement years; we will focus on employer pension plans while most employer plans used to be defined benefit pension plans, today most are defined contribution pension plans, and almost all new pension plans are defined contribution plans; reasons for the movement away from defined benefit plans include (1) government regulations and accounting standards making them costly and complicated to administer, (2) employers' increasing desire to avoid the risk of these plans (including increasing lifespan of retired employees), and (3) a shift from employee/employer long-term loyalty)

(pension plans are designed to provide income to individuals during their retirement years; we will focus on employer pension plans)

Error Discovered in the Same Reporting Period That It Occurred

(simply reverse the incorrect entry and make the correct entry; or make a correcting entry to get to the correct account balances)

Changes in the PBO

(the PBO balance will change over time for five different reasons, two of which we will discuss in depth and one only briefly)

Defined Contribution Pension Plans

(the amount of the employer contribution is defined by the plan; the funds are invested (usually with input from the employee choosing among designated funds based on their risk preferences), and the employee will get retirement income based on how well the fund has grown over time; the employee bears the risk of the investment returns; the employer bears no risk once the contributions are made, and the accounting is simple for the employer-simply debit Pension Expense and credit Cash for the contributions made)

Part A-Accounting Changes

(the first part of the chapter covers three types of accounting changes, two of which we will specifically cover: changes in accounting principle (a change from one generally accepted accounting principle to another) and changes in accounting estimate (a revision in estimate because of new information))

Recognizing the Fair Value of Options

(we measure the fair value of the options at the grant date and then record that amount as compensation expense over the service period for which the options are granted; an option pricing model (a finance topic beyond the scope of our class) is used to determine the fair value of the options; the total value of the options is expensed over the service/vesting period; usually the vesting period is several years, and the employees must stay with the company for that period to keep their options; as the amount is expensed over the vesting period, it is added to Paid in Capital-Stock Options)

3. Return on Plan Assets

(we use the expected return, which decreases pension expense)

Convertible Bonds

Bonds that can be converted into common stock at the bondholder's option (add back to the numerator the after-tax bond interest that wouldn't have been subtracted in calculating net income if the bonds had instead been converted to stock; add back to the denominator the number of additional shares of common stock that would have been outstanding if the bonds had been converted)

Correction of Accounting Errors

Caused by a transaction being recorded incorrectly or not recorded at all (when errors are discovered, they need to be corrected; they are corrected using the retrospective method: (1) a journal entry is made to correct any incorrect amounts, (2) previous years' financial statements presented for comparison are changed to reflect the correct amounts, (3) if retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to beginning retained earnings, (4) a disclosure note should describe the error and the impact of its correction)

Change in Accounting Estimate

Change in an accounting estimate that results from new information, subsequent developments, or improved judgment that impacts current and future periods. (changes in estimate are treated using the prospective method; prior period amounts are not restated, but the new estimate is used for current and future period calculations) Changing Depreciation, Amortization, and Depletion Methods (a change in the method of depreciation, amortization, or depletion is considered to be a change in estimate achieved by a change in accounting principle; these changes are treated as changes in estimate using the prospective method)

The Prospective Approach:

Changing Depreciation, Amortization, and Depletion Methods (see information below about these changes)

Accumulated Benefit Obligation

Compensation rights that employees can carry forward to future periods if not used in the period in which earned. Measure of benefits to be paid at retirement based on current salary levels. (the accumulated benefit obligation (ABO) represents the present value of future expected retirement benefits to be paid based on salaries already earned (accumulated))

Components of Pension Expense

Components of pension expense: 1. Service Costs 2. Interest of the liability 3. Actual Return on Plan Assets 4. Amortization of Prior Service Costs 5. Gain or loss

Prior Period Adjustments

Corrections of accounting errors made in previous accounting periods. Companies correct such errors by making proper entries in the accounts and reporting the corrections in the financial statements (as an adjustment to the beginning balance of retained earnings) in the year in which they are discovered. If a company prepares comparative financial statements, it should restate the prior statements for the effects of the error. (the prior period adjustment is applied to beginning retained earnings for the year following the error, or for the earliest year being reported in the comparative financial statements if the error occurred before then)

Diluted Earnings Per Share

Earnings per share calculation that requires dilutive securities be added to the denominator of the basic EPS calculation. (if a company has no potential common shares outstanding, it has a simple capital structure and only needs to report basic EPS; if it has potential common shares outstanding, it has a complex capital structure and needs to report both basic EPS and diluted EPS; diluted EPS is a hypothetical number showing the dilutive effective of all potential common shares; it is important even though it is not a historical number like basic EPS, because potential dilution now could become actual dilution later, and this would be relevant to existing financial statement users)

The Prospective Approach:

Effects of a change are reflected in the financial statements of only the current and future years When Retrospective Application is Impracticable (if it is impracticable to use the retrospective method, the prospective method may be used; for example, if a company switches to the LIFO method of inventory valuation, it is unlikely the records exist to determine prior years' LIFO layers; in the case, the new method is simply applied to the current and future periods, and prior period comparative statements are not restated; [if some, but not all, prior period effects can be calculated or if the cumulative effect on prior years cannot be determined, retrospective adjustment would take place in the earliest year practicable-not a big focus in our class])

Fair Value of Plan Assets =

Funding + Expected Return on Assets - Payments

Options, Rights, and Warrants

Give holders the right to exercise their option to purchase common stock, at a specified exercise price (use the treasury stock method in calculating diluted EPS if the options, warrants, or rights are dilutive; this will occur only when the average market price of the stock for the year exceeds the exercise price of the option, warrant, or right; the treasury stock method assumes (1) the options, warrants, or rights were exercised and additional shares of stock were issued, (2) the assumed money from the assumed exercise is used to buy back treasury shares at the average market price for the year, (3) the difference between the number of shares assumed issued minus the number of treasury shares assumed repurchased is added to the denominator in calculating diluted EPS; the assumed exercise happens at the beginning of the year or when the option, warrant, or right was issued, whichever comes later; because there is an assumed change to the denominator but no assumed change to the numerator, the "earnings per incremental share" of dilutive options, warrants, or rights is always $0 ($0/assumed change to the denominator; this becomes relevant later)

Stock Option Plans

Incentive program that allows eligible employees to buy a specific number of shares of company stock at a set price on a specified date. (employees are given the option to buy (a) a specified number of shares of the firm's stock, (b) at a specified price, ( c) during a specified period of time; as the value of the stock increases, the value of the options also increases)

Defined Benefit Pension Plans

Plans in which the company promises to pay a certain annual amount (defined benefit) to the employee after retirement. The company bears the investment risk of the plan assets.

Convertible Preferred Stock

Preferred stock with an option to exchange it for common stock at a specified rate. (add back to the numerator the preferred dividends that wouldn't have been subtracted if the preferred stock had instead been converted to common stock; add back to the denominator the number of additional shares of common stock that would have been outstanding if the preferred stocks had been converted)

Potential Common Shares

Securities that, while not being common stock may become common stock through their exercise, conversion, or issuance and therefore dilute (reduce) earnings per share. (things such as options, warrants, right, convertible bonds, or shares of convertible preferred stock which could be exercised or converted to become more shares of common stock)

Antidilutive Securities

Securities, which upon conversion or exercise, increase earnings per share (or reduce the loss per share). Companies with complex capital structures will not report diluted EPS if the securities in their capital structure are antidilutive; they will report only the basic EPS number. (if the assumed exercise or conversion of potential common shares outstanding would increase the EPS, these items are antidilutive and are not considered for diluted EPS, but they would be included in the disclosure notes; if a company has a basic loss per share, no assumed exercise or conversion of potential common shares could reduce EPS; in these cases, all options, warrants, rights, convertible bonds, and shares of convertible preferred stock are antidilutive, and they are not considered for diluted EPS)

Projected Benefit Obligation (PBO) =

Service Cost + Interest Cost - Payments

Stock Dividends and Stock Splits

Stock dividends and stock splits received are not "taxable events." When a stock dividend or stock split is "paid"; the issuer sends extra shares to the stockholder, with each share having a reduced real value. For tax purposes, the cost basis of the stock is adjusted for the stock split or stock dividend; no tax is due until the security is sold (if it is sold at a gain). Example: if a stock has a cost basis of $60 per share; and there is a 20% stock dividend; the cost basis is adjusted to $60 / 1.2 = $50 per share for the stock dividend. Notice that this is the same adjustment as that made to the market price of the stock on the ex date. Under IRS rules, stock dividends are not taxable at the time of receipt. The stock dividend results in the cost basis per share being reduced, with the number of shares held increased proportionately. In aggregate, the customer's cost basis remains the same. (stock dividends and stock splits divide the total value of the company into more pieces, each piece being smaller than it was before; therefore, stock dividends and stock splits have to be treated retroactive to the beginning of the year (to treat all shares as the same size for the year) for the current-year EPS calculation; they would need to be treated retroactive to the beginning of the first year presented for comparative purposes in comparative financial statements)

Vested Benefit Obligation

The employer's pension obligation that is computed using current salary levels and includes only vested benefits. (the vested benefit obligation (VBO) is the portion of the ABO that plan participants are entitled to receive regardless of their continued employment [we will not focus on the VBO])

The Retrospective Approach:

The new standard is applied to all periods presented in the financial statements. That is, we restate prior period financial statements as if the new accounting method had been used in those prior periods. We revise the balance of each account affected to make those statements appear as if the newly adopted accounting method had been applied all along. Most Changes in Accounting Principle (most voluntary changes in accounting principle are treated retrospectively; this means we report all prior period financial statements (at least those which will be presented as comparative statements) as if the new method had been used in those prior periods; when a change in principle is made any time during a fiscal year, it is treated as having been made as of the beginning of that year)

The Modified Retrospective Approach

The new standard is applied to the adoption period only. Prior period financial statements are not restated. The cumulative effect of the change on prior periods' net income is shown as an adjustment to the beginning balance of retained earnings in the adoption period. (when a new accounting standard mandates a change in accounting principle, the FASB may specify the approach for handling the change or may give companies a choice of how to handle the change: using the retrospective method, the prospective method, or a modified retrospective method; the modified retrospective method applies the new principle only to the adoption period (not to prior periods for comparative statements) and adjusts the beginning retained earnings for the current period; numbers reported in comparative statements are not adjusted)

Reacquired Shares

The shares that used to be in the hands of stockholders but were bought back (if shares are reacquired during the year, the weighted average number of shares outstanding is reduced by the number of shares repurchased, weighted for the fraction of the year these shares were not outstanding)

Change in Accounting Principle

Use of an accounting principle in the current year different from the one used in the preceding year. (while consistency in the application of accounting principles leads to increased comparability, it is sometimes appropriate to change accounting principles; sometimes companies have arbitrary choices between or among different accounting principles; in other cases, the circumstances, which can change, dictate between competing accounting principles to be applied; if circumstances change such that a change in accounting principle is either dictated or preferred to enhance the accounting information provided, we need to know how to account for the change; of course, we would not expect to see a lot of accounting changes, as they reduce comparability; we would also not expect companies to switch back and forth, as there would not be justification for doing so)

Convertible Securities

a bond or share of preferred stock that gives its holder the right to exchange it for a stated number of shares of common stock (in considering convertible securities for diluted EPS, we use the if- converted method; convertible securities are only included in diluted EPS if they are actually dilutive; under the if-converted method, convertible securities are assumed converted at the beginning of the year or when the convertible security was issued, whichever is later)

Two qualitative characteristics of accounting information that contribute to relevance and representational faithfulness are

consistency and comparability. While we strive to achieve these attributes, changes in the economy, in specific industries, or in accounting principles sometimes lead to new required accounting methods or voluntary changes in accounting methods.

Pension Plan Assets

employer contributions and accumulated earnings on the investment of those contributions to be used to pay retirement benefits to retired employees. (the employer needs to invest money such that enough will be available to pay the promised benefits; the plan assets increase by (1) any employer contributions/funding and (2) the return on plan assets-we use the expected return rather than the actual return in this calculation, as we will use the expected return later in calculating pension expense; plan assets will decrease for any amounts paid out to existing retirees (we will discuss this last item only briefly))

Service cost

increase in the projected benefit obligation attributable to employee service performed during the period. (this is the increase in the PBO due to the employees having worked one more year, thus earning more retirement benefits; it is an amount calculated for each separate year of the service period; it is the present value (at year end) of the retirement benefits earned by the employees for having worked during that one year; it increases the PBO, as it increases the amounts owed in the future)

Earnings Available to Common Shareholders

net income - preferred dividends (net income minus any claim by senior securities such as preferred shareholders; preferred dividends are subtracted in the numerator if (1) the preferred stock is cumulative, or (2) the preferred dividends were declared)

Projected Benefit Obligation

obligation of a company to its employees in regard to its pension plan for the work they have done to date (the projected benefit obligation (PBO) is the present value of the expected future retirement benefits to be paid based on future (projected) salary levels prior to retirement [we will mostly focus on the PBO, although we will also look at the ABO]; the PBO is less reliable than the ABO, but it is more relevant and representationally faithful)

The Prospective Approach:

the accounting change is implemented in the present, and its effects are reflected in the financial statements of the current and future years only. When Mandated by Authoritative Accounting Literature (the prospective method is applied if a mandated change in accounting principle requires it)

The Pension Obligation

the deferred compensation obligation it has to its employees for their service under the terms of the pension plan

Reporting the Funded Status of the Pension Plan

the funded status of the pension plan is the difference between the PBO and the plan asset balance; if the plan asset balance is greater, we have an overfunded amount; if the PBO is greater, we have an underfunded amount)

When Options are Exercised

when options are exercised, the company debits Cash for the amount of the option price received, debits Paid-in Capital-Stock Options for the amount related to the options exercised, and credits Common Stock (and likely Paid-in Capital-Excess of par) to record the stock issued