Chapter 6 Discussion ?s

What are the economic costs to issuing employee stock options at the prevailing market price?

(1) the interest cost (the employee is able to pay for the stock purchase many years later using the current stock price) (2) the employee can share in the potential upside but is protected from sharing in the potential downside risk.

List four general cases giving rise to temporary differences between financial reporting and tax reporting?

(a) Revenues or gains are included in taxable income later than they are included in pretax accounting income. (b) Expenses or losses are deducted in determining taxable income later than they are deducted in determining pretax accounting income. (c) Revenues or gains are deducted in taxable income earlier than they are included in pretax accounting income. (d) Expenses or losses are deducted in determining taxable income earlier than they are deducted in determining pretax accounting income.

Net income computed on the basis of financial reporting often differs from taxable income due to permanent differences. What are permanent differences and how do they arise?

(also known as "book income") is usually not identical to the "taxable income" computed on the entity's tax return. Bc of 1) Permanent differences 2) temporary, or timing, differences. Permanent differences result from provisions of the tax law under which: (a) Certain items may be nontaxable-for example, proceeds of life insurance on an officer (b) Certain deductions are not allowed-for example, government fines, and officer life insurance premiums. (c) Special deductions granted by law-for example, dividend exclusion on dividends received from other domestic corporations.

What is the purpose underlying the reporting of diluted EPS?

Diluted earnings per share is the amount of current earnings per share reflecting the maximum dilution that would result from conversions, exercises, and other contingent issuances that individually would decreased earnings per share and in the aggregate yield a dilutive effect. All such issuances are assumed to have taken place at the beginning of the period

What conditions are necessary for an item to qualify as a prior period adjustment?

1) Material in amount. 2) identifiable with the business activities of specific prior periods. 3) Not attributable to economic events occurring after the prior period. 4) Dependent on determinations by persons other than management. 5) Not reasonably estimable prior to such determination.

What factors cause the effective tax rate to differ from the statutory rate?

1) The basis of carrying property for accounting purposes may differ from that for tax purposes from reorganizations, business combinations, or other transactions. 2) Nonqualified and qualified stock option plans may result in book tax differences. 3) Certain industries, such as savings and loan associations, shipping lines, and insurance companies enjoy special tax privileges. 4) Up to $100,000 of corporate income is taxed at lower tax rates. 5) Certain credits may apply, such as R&D credits and foreign tax credits. 6) State and local income taxes, net of federal tax benefit, are included in total tax expenses. What makes these differences and factors permanent is the fact that they do not have any future repercussions on a company's taxable income. Thus, they must be taken into account when reconciling a company's actual (effective) tax rate to the statutory rate.

Describe the conditions that are usually required before revenue is considered realized.

1) The earning activities undertaken to create revenue are substantially complete 2) In the case of a sale, the risk of ownership has effectively passed to the buyer. 3) The revenue & expenses, can be measured or estimated with substantial accuracy. 4) The revenue recognized should normally result in an increase in cash, receivables, or marketable securities and, under certain conditions, in an increase in inventories or other assets, or a decrease in a liability. 5) The business transactions giving rise to the income should be at arm's length with independent parties (that is, not with controlled parties). 6) The transactions should not be subject to revocation, for example, carrying the right of return of merchandise sold.

How does accounting define an extraordinary item? Cite three examples of such an item. What are the analysis implications of such an item?

Accounting standards requiring that an extraordinary item be both unusual in nature and infrequent in occurrence. These attributes are defined as follows: a. Unusual nature of the underlying event or transaction should possess a high degree of abnormality and be unrelated/incidentally related to, the ordinary and typical activities of the entity, taking into account the environment the entity operates. b. Infrequency of occurrence of the underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates. Three examples of extraordinary items are: 1) Major casualty losses from an event such as an earthquake, flood, or fire. 2) A gain or loss from expropriation of property. 3) A gain or loss from condemnation of land by eminent domain (when the gov takes ur land for public use and pays you for it)

Distinguish between net income, comprehensive incomes, and continuing income. Cite examples of items that create differences between these three income measures.

Net income is the excess of the revenues and gains of the company over the expenses and losses of the company. Comprehensive income includes all changes in equity that result from non-owner transactions. Items creating differences between net income and comprehensive income include unrealized gains and losses on available for sale securities & derivative instruments, foreign currency translation & minimum pension liability adjustments. Comprehensive income is the ultimate "bottom line" income number. Continuing income is a measure of net income earned by ongoing segments of the company. Continuing income differs from net income because excludes the income or loss of segments of the company that are to be discontinued or sold (excludes extraordinary items and effects from changes in accounting principles).

Explain what special items are. Give three examples of special items.

Special items refer to transactions and events that are unusual or infrequent, not both. These items are reported as separate line items on the income statement before continuing income. Examples : restructuring charges, impairments of long-lived assets, and asset write-offs.

Distinguish between operating and non-operating income. Cite examples of items that are typically included in each category.

Operating income is a measure of firm performance from operating activities. Examples: product sales, cost of product sales, and selling, general, and administrative costs. Non-operating income includes all components of income not included in operating income. Examples: interest revenue and interest expense.

Distinguish between the two major methods used to account for revenue under long-term contracts.

Percentage of completion method is preferred when estimates of costs to complete the contract can be made with reasonable dependability. A common basis of profit estimation is to record that part of the estimated total profit that corresponds to the ratio that costs incurred to date bears to expected total costs. Other methods of estimation of completion can be based on units completed or on qualified engineering estimates or on units delivered. The completed contract method of accounting is preferable where the conditions inherent in the contract present risks and uncertainties that result in an inability to make reasonable estimates of costs and completion time. Problems under this method concern the point at which completion of the contract is deemed to have occurred as well as the kind of expenses to be deferred. For example, some companies defer all costs to the completion date, while others consider such costs as period costs to be expensed as they are incurred. Under either of the two contract accounting methods, losses must be fully provided for in the period in which the loss first becomes apparent.

Describe the calculation of compensation expense associated with employee stock options. Is it necessary for a company to charge option-related compensation expense to income? Where in the income statement is compensation expenses reported?

Statement of Financial Accounting Standards 123 requires that the company amortize (paying off debt) the fair value of employee stock options at the grant date over the expected life of the option. The cumulative amortization of all employee stock options granted in the past is called the option compensation expense. A recent revision of the standard, requires that the option compensation expense be charged to income. Compensation expense may be included in various expense categories such as cost of goods sold, selling general & administrative , research & development etc. based on which area of the company the respective employee works for.

Describe the accounting treatment for discontinued operations. How should an analyst treat discontinued operations?

To qualify as discontinued operations, the assets and business activities of the divested segment must be clearly distinguishable from the remaining entity. 1) the income statement for the current and prior two years are restated after excluding the effects of the discontinued operations from the line items that determine income. 2) Gains or losses pertaining to the discontinued operations are reported separately, net of related tax effects. An analyst should separate and ignore discontinued operations in predicting future performance and financial condition.

What is option overhang? What does it measure? How is it determined?

intrinsic value of outstanding options as a proportion of the company's market value. measure of the value of potential dilution that arises from option grants to employees. It measured by aggregating the intrinsic value of all outstanding employee stock options, =current stock price/the current market capitalization of the company's equity

Analysts often refer to the core income of a company. What is meant by the term core income?

measure of income that excludes all non-recurring items that are reported as separate items on the income statement.

List and discuss the factors that affect the fair value of an option

the current market price, the risk-free rate of interest, the expected life of the option, the expected volatility of the stock price, and the expected dividend yield.