ACG 4803 (CH 24 - Full Disclosure in Financial Reporting)
Two types of events or transactions occurring after the balance sheet date may have a material effect on the financial statements or may need disclosure so that readers interpret these statements accurately:
1. RECOGNIZED SUBSEQUENT EVENTS - Events that provide additional evidence about conditions that existed at the balance sheet date, including the estimates inherent in the process of preparing financial statements.(REQUIRE ADJUSTMENTS TO FINANCIAL STATEMENTS) 2. NON RECOGNIZED SUBSEQUENT EVENTS - Events that provide evidence about conditions that did not exist at the balance sheet date but arise subsequent to that date. (ADJUSTMENT TO FINANCIAL STATEMENTS NOT NECESSARY)
Disclosure is not required for what type of nonrecognized subsequent events?
Disclosure not required for non-accounting events or items disclosed some other way (e.g., press releases) (ex.Legislation, Product changes, Management changes, Strikes, Unionization, Loss of important customers)
The FASB has responded by initiating a Disclosure Framework project to improve the effectiveness of disclosures in notes to financial statements by clearly communicating the information that is most important to users of financial statements. To achieve this objective, the Disclosure Framework project comprises two components:
(1) the Board's decision process and (2) the entity's decision process.
Percent Change Formula
(Current yr - Prior Yr) / Prior yr
Examples of nonrecognized subsequent events:
(a)Sale of a bond or capital stock issued after the balance sheet date. (b)A business combination that occurs after the balance sheet date. (c)Settlement of litigation when the event giving rise to the claim took place after the balance sheet date. (d)Loss of plant or inventories as a result of fire or natural disaster that occurred after the balance sheet date. (e)Losses on receivables resulting from conditions (such as a customer's major casualty) arising after the balance sheet date. (f)Changes in the quoted market prices of securities or foreign exchange rates after the balance sheet date. (g)Entering into significant commitments or contingent liabilities, for example, by issuing significant guarantees after the balance sheet date.
Ratio Analysis Comparesparts of the financial statements to each other to better understand position of the company. What are the 4 major types we cover?
-Liquidity -Activity -Profitability -Coverage
(PROFITABILITY RATIOS) -Success generating value from operations:
-Profit margin on sales -Return on assets
Disclosure issues include
-Related Party Transactions -Post-Balance-Sheet Events (Subsequent Events) -Reporting for Diversified (Conglomerate) Companies -Management's Discussion and Analysis -Forecasts and Projections -Financial Statement Analysis
(PROFITABILITY RATIOS) -Success generating value for shareholders:
-Return on common stock equity -Earnings per share -Payout ratio
Management's Discussion and Analysis
-Unaudited additional information from management -Additional disclosures related to: liquidity, capital resources, results of operations
Cons of segmented disclosure
1. Investor needs to be knowledgeable about more industries to avoid misinterpretation 2. "Enemies" (e.g., competitors) may use information against company 3. Managers may avoid risks (even when they are worth it) for fear of how loss will look when disaggregated 4. Accounting at segment level is not always meaningful 5. Investor should not care about segments if overall performance is good 6. Preparing disclosures is hard
Pros of Segmented Disclosure
1. Investors can better forecast future profits and cash flows 2. Investors can better estimate the overall worth of a company 3. Absence of segment disclosure puts non-diversified companies at disadvantage (no where to hide all the things management wanted retain the right to hide on previous slide)
Define Financial Projection
set of future financial statements, given hypothetical conditions
Define accounting errors
Unintentional accounting mistakes.
MAJOR DISCLOSURES - Deferred Taxes, Pensions, and Leases
Users of financial statements should carefully read notes to the financial statements for information about off-balance-sheet commitments, future financing needs, and the quality of a company's earnings.
(ACT) what does the accounts receivable turnover ratio measure?
How well does the company judge credit risk and manage collections?
Why do companies advocate for segmented data for Diversified (Conglomerate) Companies?
1.Investors need segmented information to make an intelligent investment decision regarding a diversified company. (a)Sales and earnings of individual segments enable investors to evaluate the differences between segments in growth rate, risk, and profitability, and to forecast consolidated profits. (b)Segmented reports help investors evaluate the company's investment worth by disclosing the nature of a company's businesses and the relative size of the components. 2.The absence of segmented reporting by a diversified company may put its unsegmented, single product-line competitors at a competitive disadvantage because the conglomerate may obscure information that its competitors must disclose. ****The advocates of segmented disclosures appear to have a much stronger case.
After the company decides on the possible segments for disclosure, it makes a quantitative materiality test. This test determines whether the segment is significant enough to warrant actual disclosure. An operating segment is deemed significant, and therefore a reportable segment, if it satisfies one or more of the following quantitative thresholds.
1.Its revenue (including both sales to external customers and intersegment sales or transfers) is 10 percent or more of the combined revenue of all the company's operating segments. 2.The absolute amount of its profit or loss is 10 percent or more of the greater, in absolute amount, of (a) the combined operating profit of all operating segments that did not incur a loss, or (b) the combined loss of all operating segments that did report a loss. 3.Its identifiable assets are 10 percent or more of the combined assets of all operating segments. AND sum of reported segments' revenue ≥ 75% AND number of segments ≤ 10
GAAP requires which disclosures of material related-party transactions (SPECIAL TRANSACTIONS OR EVENTS) *related party transactions
1.The nature of the relationship(s) involved. 2.A description of the transactions (including transactions to which no amounts or nominal amounts were ascribed) for each of the periods for which income statements are presented. 3.The dollar amounts of transactions for each of the periods for which income statements are presented. 4.Amounts due from or to related parties as of the date of each balance sheet presented.
Why have companies always been somewhat hesitant to disclose segmented data for Diversified (Conglomerate) Companies?
1.Without a thorough knowledge of the business and an understanding of such important factors as the competitive environment and capital investment requirements, the investor may find the segmented information meaningless or may even draw improper conclusions about the reported earnings of the segments. 2.Additional disclosure may be helpful to competitors, labor unions, suppliers, and certain government regulatory agencies, and thus harm the reporting company. 3.Additional disclosure may discourage management from taking intelligent business risks because segments reporting losses or unsatisfactory earnings may cause stockholder dissatisfaction with management. 4.The wide variation among companies in the choice of segments, cost allocation, and other accounting problems limits comparability, and hence the usefulness of segmented information. 5.The investor is investing in the company as a whole and not in the particular segments, and it should not matter how any single segment is performing if the overall performance is satisfactory. 6.Certain technical problems, such as classification of segments and allocation of segment revenues and costs (especially "common costs"), are formidable.
MAJOR DISCLOSURES - Contingencies and Commitments
A company may have gain or loss contingencies that are not disclosed in the body of the financial statements. These contingencies include litigation, debt and other guarantees, possible tax assessments, renegotiation of government contracts, and sales of receivables with recourse. In addition, companies should disclose in the notes commitments that relate to dividend restrictions, purchase agreements (through-put and take-or-pay), hedge contracts, and employment contracts.
Define Operating Segment
A component of an enterprise (1) that engages in business activities from which it earns revenues and incurs expenses, (2) whose operating results are regularly reviewed by the company's chief operating decision maker to assess segment performance and to allocate resources to the segment, and (3) for which discrete financial information is available that is generated by or based on the internal financial reporting system.
(LIQ) what does the current cash debt coverage ratio measure?
Are company's cash flows sufficient to pay loans due now?
(LIQ) What does the Quick Ratio Measure?
Can company pay loans due now with REALLY liquid assets?
(LIQ) What does the Current Ratio Measure?
Can company pay loans due now with liquid assets?
MAJOR DISCLOSURES - Inventory
Companies should report the basis upon which inventory amounts are stated (e.g., lower-of-cost-or-net realizable value or lower-of-cost-or-market) and the method used in determining cost (LIFO, FIFO, average-cost, etc.). Manufacturers should report, either in the balance sheet or in a separate schedule in the notes, the inventory composition (finished goods, work in process, raw materials).
MAJOR DISCLOSURES - property, plant, equipment
Companies should state the basis of valuation for property, plant, and equipment. It is usually historical cost. Companies also should disclose pledges, liens, and other commitments related to these assets. In the presentation of depreciation, companies should disclose the following in the financial statements or in the notes: (1) depreciation expense for the period; (2) balances of major classes of depreciable assets, by nature and function, at the balance sheet date; (3) accumulated depreciation, either by major classes of depreciable assets or in total, at the balance sheet date; and (4) a general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets. Finally, companies should explain any major impairments.
MAJOR DISCLOSURES - Fair Values
Companies that have assets or liabilities measured at fair value must disclose both the cost and the fair value of all financial instruments in the notes to the financial statements. Fair value measurements may be used for many financial assets and liabilities, investments, impairments of long-lived assets, and some contingencies. Companies also provide disclosure of information that enables users to determine the extent of usage of fair value and the inputs used to implement fair value measurement.
(COV) what does the cash debt coverage ratio measure?
Does company have sufficient cash flows to cover debt obligations?
(COV) what does the debt to assets ratio measure?
Does the company have sufficient assets to cover debt that could be seized in the event of default?
The Board's decision process
Is intended to aid the FASB in identifying disclosures to be considered when setting disclosure requirements for individual accounting standards and evaluating existing disclosure requirements.
Define Management Approach of reporting for segmented information
How a company can meet the segmented reporting objective, by providing financial statements segmented based on how the company's operations are managed.
(ACT) What does the Inventory Turnover Ratio Measure?
How well does the company manage its inventory process?
(ACT) What does the asset turnover ratio measure?
How well, in general, does the company convert its assets into revenue?
Define accounting fraud
Intentional distortions of financial statements.
MAJOR DISCLOSURES - Creditor Claims
Investors normally find it extremely useful to understand the nature and cost of creditor claims. However, the liabilities section in the balance sheet can provide the major types of liabilities only in the aggregate. Note schedules regarding such obligations provide additional information about how a company is financing its operations, the costs that it will bear in future periods, and the timing of future cash outflows. Financial statements must disclose for each of the five years following the date of the statements the aggregate amount of maturities and sinking fund requirements for all long-term borrowings.
In Financial Statement Analysis think of the financial statements as a means of answering a question about the company
Investors: Would this company be a profitable investment? Creditors: If I loan money to this company will they be able to repay me?
MAJOR DISCLOSURES - Equityholder's Claims
Many companies present in the body of the balance sheet information about equity securities: the number of shares authorized, issued, and outstanding and the par value for each type of security. Or, companies may present such data in a note. Beyond that, a common equity note disclosure relates to contracts and senior securities outstanding that might affect the various claims of the residual equityholders.
Define Activity Ratios
Ratios that measure how effectively the company is using the assets employed. **** In other words: Ability to convert OPERATING or INVESTING assets into financial benefits.
Define Coverage Ratios
Ratios that measure the ability to repay long-term creditors and investors. **** In other words: How likely is it that creditors and investors will get their money back?
Define Liquidity Ratio
Ratios that measure the company's short-term ability to pay its maturing obligations. **** In other words: Can company pay the items that it HAS to be pay NOW.
Define Profitability Ratios
Ratios that measure the degree of success or failure of the company for a given period of time. **** In other words: Did the company provide value for those who provided FINANCING? Did the company use its INVESTMENTS wisely?
Disclosure of Special Transactions or Events -
Related-party transactions, errors and fraud, and illegal acts pose especially sensitive and difficult problems. The accountant/auditor who has responsibility for reporting on these types of transactions must take care to properly balance the rights of the reporting company and the needs of users of the financial statements.
Define Financial Forecast
Set of future financial statements, given expected conditions. *Safe Harbor Rule - protects company that makes an erroneous forecast as long as it was prepared on a reasonable basis.
Define Post Balance Sheet Events
Significant financial events that took place after the formal balance sheet date but before final issuance and that may materially affect the company's financial position. Also referred to as subsequent events. Some post-balance-sheet events require adjustments to the accounts. Notes to the financial statements should explain post-balance-sheet events.
Define Subsequent Events
Significant financial events that took place after the formal balance sheet date but before issuance and that may materially affect the company's financial position. Also referred to as post-balance-sheet events. Some subsequent events require adjustments to the accounts. Notes to the financial statements should explain subsequent events.
Management's Responsibility for Financial Statements
Since SOX management must expressly state responsibility for: - Financial statements - Controls over financial reporting
Should all companies have the same reporting requirements?
Some believe small companies should have less onerous requirements (ex. BIG vs LITTLE GAAP) *FASB has traditionally taken the positon that there should only be one set of GAAP
Define Differential Disclosure
The FASB, in recognizing that certain disclosure requirements are costly and unnecessary for certain companies, has eliminated reporting requirements for nonpublic enterprises in such areas as fair values of financial instruments and segment reporting.
Objective of Reporting Segmented Information
The objective of reporting segmented financial data is to provide information about the different types of business activities in which an enterprise engages and the different economic environments in which it operates.
MAJOR DISCLOSURES - Changes in Accounting Principles
The profession defines various types of accounting changes and establishes guides for reporting each type. Companies discuss, either in the summary of significant accounting policies or in the other notes, changes in accounting principles (as well as material changes in estimates and corrections of errors).
Define Accounting Policies
The specific accounting principles and methods a company currently uses and considers most appropriate to present fairly its financial statements.
Define Illegal Acts
Violations of laws and regulations, such as illegal political contributions, bribes, and kickbacks. If a company derives revenue from an illegal act that is considered material in relation to the financial statements, this information should be disclosed. *The Sarbanes-Oxley Act is intended to deter these illegal acts.
(COV) what does the book value per share ratio measure?
What is the return to a shareholder if company liquidates?
Define Related Party Transactions
When a company engages in transactions in which one of the parties has the ability to significantly influence the policies of the other. Related-party transactions may also occur when a nontransacting party has the ability to influence the policies of the two transacting parties. (ex. e.g., General Motors and parts suppliers or buying a car from your parents)
(COV) what does the times interest earned ratio measure?
Will company be able to keep up with interest payments?
The Entity's Decision Process
addresses the decisions that companies make in determining what to disclose. Guidance for companies to make disclosure decisions will not be part of the Conceptual Framework but instead will be exposed separately in a proposed Accounting Standards Update.
Notes to the Financial Statements -
are the means of amplifying or explaining the items presented in the main body of the statements. They can explain in qualitative terms information pertinent to specific financial statement items. In addition, they can provide supplementary data of a quantitative nature to expand the information in the financial statements. Notes also can explain restrictions imposed by financial arrangements or basic contractual agreements. Although notes may be technical and difficult to understand, they provide meaningful information for the user of the financial statements.
GAAP states that companies should report their accounting policies how?
as an integral part of the financial statements a statement identifying the accounting policies adopted and followed by the reporting entity. (Ex.What method of depreciation is used on plant assets? What valuation method is employed on inventories? What amortization policy is followed in regard to intangible assets? How are marketing costs handled for financial reporting purposes?)
The accounting profession has adopted a "Full Disclosure Principle" this principle calls for what?
financial reporting of any financial facts significant enough to influence the judgment of an informed reader. In some situations, the benefits of disclosure may be apparent but the costs uncertain. In other instances, the costs may be certain but the benefits of disclosure not as apparent.
Disclosure requirements have increased substantially, the reasons for this increase in disclosure requirements are:
•Complexity of the business environment. The increasing complexity of business operations magnifies the difficulty of distilling economic events into summarized reports. Such areas as derivatives, leasing, business combinations, pensions, financing arrangements, revenue recognition, and deferred taxes are complex. As a result, companies extensively use notes to the financial statements to explain these transactions and their future effects. •Necessity for timely information. Today, more than ever before, users are demanding information that is current and predictive. For example, users want more complete interim data. Also, the SEC recommends published financial forecasts, long avoided and even feared by management. •Accounting as a control and monitoring device. The government has recently sought public disclosure of such phenomena as management compensation, off-balance-sheet financing arrangements, and related-party transactions. An "Enronitis" concern is expressed in many of these newer disclosure requirements, and the SEC has selected accountants and auditors as the agents to assist in controlling and monitoring these concerns.