ACCT ch 4

Discontinues operations occurs when two things happen:

"1) a company eliminates the results of operations of a component of the business 2) the elimination of a component that represents a strategic shift, having a major effect on the company's operations and financial results.

Discontinues operation amounts are reported _____

"net of tax"

Identify at least two situations in which application of different accounting methods or accounting estimates result in difficulties in comparing companies.

(a) Inventory methods—LIFO vs. FIFO, (b) Depreciation Methods—straight-line vs. accelerated, (c) Accounting for long-term contracts—percentage-of-completion vs. completed-contract, (d) Estimates of useful lives or salvage values for depreciable assets, (e) Estimates of bad debts, (f) Estimates of warranty costs

Discuss the appropriate treatment in the financial statements of each of the following: a) gain on sale of investment securities b) a profit sharing bonus to employees computed as a percentage of net income c) additional depreciation on factory machinery because of an error in computing depreciation for the previous year.

(a) This transaction will be shown in the income statement in the "Other revenues and gains" section. (b) The bonus should be shown as an operating expense in the income statement. Although the basis of computation is a percentage of net income, it is an ordinary operating expense to the company and represents a cost of the service received from employees. (c) If the amount is immaterial, it may be combined with the depreciation expense for the year and included as a part of the depreciation expense appearing in the income statement. If the amount is material, it should be shown in the retained earnings statement as an adjustment to the beginning balance of retained earnings.

Identify at least two situations in which important changes in value are not reported in the income statement.

(a) Unrealized gains or losses on available-for-sale investments, (b) Changes in the fair values of long-term liabilities, such as bonds payable, (c) Changes (increases) in value of property, plant and equipment, such as land, natural resources, or equipment, (d) Changes (increases) in the values of intangible assets such as customer goodwill, brand value, or intellectual capital.

Earnings per share formula:

(net income - preferred dividends) / Weighted average of Common Shares Outstanding

Illustration: Arcadia HS, purchased equipment for $510,000 which was estimated to have a useful life of 10 years with a salvage value of $10,000 at the end of that time. Depreciation has been recorded for 7 years on a straight-line basis. In 2017 (year 8), it is determined that the total estimated life should be 15 years with a salvage value of $5,000 at the end of that time. Questions: -What is the journal entry to correct the prior years' depreciation? -Calculate the depreciation expense for 2017.

(see slides 39-41 for answers)

Examples of Change in accounting principle include:

*change from FIFO to average cost *change from the percentage-of-completion to the completed contract method.

Examples of expense accounts include:

-COGS -depreciation -interest -rent -salaries and wages -taxes

Intermediate Components of the income statement:

-Format referred to as multiple-step income statement -separates operating from non operating transactions -matches cost and expenses with related revenues -highlights certain components of income that analysts use assessing financial performance.

Operating section includes:

-Sales or revenue -COGS -Selling expenses -Administrative or General expenses

Earnings per share is:

-a significant business indicator -measures the dollar earned by each share of common stock -must be disclosed on the income statement

Change in accounting estimates:

-accounted for in the period of change or the period of and the future periods if the change affects both. -not handled retrospectively -not considered errors.

Comprehensive income includes:

-all revenues and gains, expenses and losses reported in net income -all gains and losses that bypass net income but affect stockholders' equity

Intraperiod tax allocation

-allocation of tax w/in a period -helps users understand the impact of income taxes on the various components of net income

Accounting changes and error include:-

-changes in accounting principles -change in estimates -corrections of errors require unique reporting provisions

Limitations of an Income statement

-companies omit items that cannot be measured reliably -income is affected by the accounting methods employed -income measurement involves judgment.

The following items are disclosed in the statement of stockholders' equity:

-contributions (issuances of shares) and distributions (dividends) to owners. -reconciliation of the carrying amount of each component of stockholders' equity from the beginning to the end of the period.

Correction of errors are:

-corrections treated as prior period adjustments -adjustments to the beginning balance of retained earnings.

Both GAAP and IFRS follow the same presentation guidelines for ________, but IFRS defines a discontinued operation more narrowly. Both standard-setters have indicated a willingness to develop a similar definition to be used in the joint project on financial statement presentation.

-discontinued operations

Usefulness of an Income statement

-evaluates past performance -predicting future performance -help assess the risk of uncertainty of achieving future cash flows

Common types of unusual or infrequent gains and losses:

-losses on write-down (impairment) of receivables; inventories; property, plant, and equipment; goodwill or other intangible assets. -restructuring charges -gains and losses from sale or abandonment of property, plant and equipment -effects of a strike -gains and losses on extinguishment (redemption)of debt obligations. -gains and losses related to casualties such as fires, floods, and earthquakes -gains or losses on sale of investment securities.

Quality of Earnings: Companies have incentives to manage income to meet or beat Wall Street expectation so that:

-market price of stock increases and -value of stock options increase

Correction from errors result from:

-mathematical mistakes -mistakes in application from accounting principles -oversight or misuse of facts

Increases on a Retained Earnings statement:

-net income -change in accounting principle -prior period adjustments

Decreases on a Retained Earnings statement:

-net loss -dividends -changes in accounting principles -prior period adjustments

Non operatin section includes:

-other revenues and gains -other expenses and losses

______ is reduced if ________ results in information that is less useful for predicting future earnings and cash flows.

-quality of earnings -earnings management

Change in accounting principle:

-retrospective adjustment -cumulative effect adjustment to beginning retained earnings -approach preserves comparability across years

Elements of the financial statement include:

-revenues -expenses -gains -losses

Gains and losses can result from:

-sale of investments or plant assets -settlement of liabilities -write offs of assets

Examples of revenue accounts include:

-sales -fees -interest -dividend -rent

Companies are required to report ________ and _______ items as part of net income so users can better determine the long-run earning power of the company.

-unusual -infrequent

Examples of change in accounting estimates include:

-useful lives and salvage values of depreciable assets -allowance for uncollectible receivable -inventory obsolescence.

Intraperiod tax allocation is used for:

1) income from continuing operations 2) discontinued operations

What kinds of questions about future cash flows do investors and creditors attempt to answer with information in the income statement?

1. evaluate past performance of the enterprise 2. determine risk (level of uncertainty) of income- revenues, expenses, gains, and losses- and highlights the relationship among these various components

Sections of the multiple-step income statement include:

1. operating section 2. non operating section 3. income tax 4. discontinued operations 5. non controlling interest 6. earnings per share

Companies must display the components of other comprehensive income in one of two ways:

1. single continuous statement (one statement approach) 2- two separate, but consecutive statements of net income and other comprehensive income (two statement approach)

Modified all inclusive concept: These income items fall into 4 general categories:

1. unusual gains and losses 2. discontinued operations 3. non-controlling interest 4. earnings per share

Which of the following is not an acceptable way of displaying the components of other comprehensive income under IFRS? A) Within the statement of retained earnings. B) Second income statement. C) Combined statement of comprehensive income. D) All of the above are acceptable.

A) within the statement of retained earnings

What are the advantages and disadvantages of the single step income statement?

Advantages: (1) simplicity and conciseness, (2) probably better understood by the layperson, (3) emphasis on total costs and expenses, and net income, and (4) does not imply priority of one revenue or expense over another. Disadvantages:it does not show the relationship between sales revenue and cost of goods sold and it does not show other important relationships and information, such as income from operations, income before income tax, etc.

Retained earnings statement example problem: (slide 46 and 47, pg. 173, illustration 4-19)

Before issuing the report for the year ended December 31, 2017, you discover a $50,000 error (net of tax) that caused 2016 inventory to be overstated (overstated inventory caused COGS to be lower and thus net income to be higher in 2016). Would this discovery have any impact on the reporting of the Statement of Retained Earnings for 2017?

Why should caution be exercised in the use of the net income figure derived in an income statement?

Caution should be exercised because many assumptions and estimates are made in accounting and the net income figure is a reflection of these assumptions. If for any reason the assumptions are not well-founded, distortions will appear in the income reported.

Distinguish between the modified all-inclusive income statement and the current operating performance income statement.

Current operating performance income statement: contains only the revenues and usual expenses of the current year, with all unusual gains or losses or material corrections of prior periods' revenues and expenses appearing in the retained earnings statement. Modified all inclusive income statement: includes most items including irregular ones, as part of net income. The retained earnings statement then would include only the beginning balance (adjusted for the effects of errors and changes in accounting principle), the net amount transferred from income summary, dividends, and transfers to and from appropriated retained earnings.

Change in Accounting principle example problem:(slide 37, pg. 170-172, illustration 4-16 and 4-17)

Gaubert Inc. decided in March 2017 to change from FIFO to weighted-average inventory pricing. Gaubert's income before taxes, using the new weighted-average method in 2017, is $30,000.

Non controlling interest example problem: (slide 30, pg. 167, illustration 4-12)

Illustration: Assume that Coca-Cola acquires 70 percent of the outstanding stock of Koch Company. Because Coca-Cola owns more than 50 percent of Koch, it consolidates Koch's financial results with its own. GAAP requires that net income be allocated to the controlling and noncontrolling interest.

Accounting errors example problem: (slide 43, pg. 172)

Illustration: In 2018, Hillsboro Co. determined that it incorrectly overstated its accounts receivable and sales revenue by $100,000 in 2017. In 2018, Hillboro makes the following entry to correct for this error (ignore income taxes).

Earning per share example problem: (slide 32, pg. 168, illustration 4-13)

Illustration: Lancer, Inc. reports net income of $350,000. It declares and pays preferred dividends of $50,000 for the year. The weighted-average number of common shares outstanding during the year is 100,000 shares. Lancer computes earnings per share as follows:

Discontinued operations (Gain) example problem: (slide 27, pg. 166, illustration 4-9)

Illustration: Schindler Co. has income before income tax of $250,000. It has a gain of $100,000 from a discontinued operation. Assuming a 30 percent income tax rate, Schindler presents the following information on the income statement.

Discontinued operations (loss) example problem: (slide 28, pg. 166, illustration 4-10)

Illustration: Schindler Co. has income before income tax of $250,000. It suffers a loss from discontinued operations of $100,000. Assuming a 30 percent tax rate, Schindler presents the income tax on the income statement as shown

Income tax section example:

Income before income tax - income tax = net income for the year

Discontinues operations example: (slide 24, pg. 164)

Income from continuing operations DISCONTINUED OPERATION: Loss from operations (net of tax) + Loss on disposal (net of tax) = total loss on discontinues operations Income from continuing operations - total loss on discontinued operations = Net income

Gains

Increases in equity (net assets) from peripheral or incidental transactions

How can earnings management affect the quality of earnings?

It has a negative effect on the quality of earnings if it distorts the information in a way that is less useful for predicting future cash flows. Within the Conceptual Framework, useful information is both relevant and representationally faithful. However, earnings management reduces the reliability of income, because the income measure is biased (up or down) and/or the reported income is not representationally faithful to that which it is supposed to report (e.g., volatile earnings are made to look more smooth).

How should correction of errors be reported in the financial statements?

Items considered corrections of errors should be charged or credited to the opening balance of retained earnings.

Condensed Income statement set up:

Net sales - COGS = Gross profit - (Selling expense + administrative expenses) = income from operations + other revenues and gains = $$$ - other expenses and losses = income before income tax - income tax = net income for the year = earnings per common share

Non operating section example:

OTHER REVENUES & GAINS *list of revenues= total *Income from operations+ total other revenues and gains = new total OTHER EXPENSES & LOSSES * list of expenses = total other expenses and losses * New total - total other expenses and losses = Income before income tax

What is the basis for distinguishing between operating and nonoperating items?

Operating items: expenses and revenues which relate directly to the principal activity of the company; they are the revenue and expenses which contribute to the sale of goods or services for which a company was organized. Non operating items: a report of the revenues and expenses resulting from secondary or auxiliary activities of the company. In addition, gains and losses that are infrequent or unusual, or both, are normally reported in the section. Generally these breakdown into two main subsections: "Other revenues and gains" and "Other expenses and losses."

Single step income statement formula:

Revenues - expenses = net income

Operating section example:

SALES Sales revenue - (sales discount + sales r&a) = net sales - COGS = Gross profit OPERATING EXPENSES Selling expenses (a + b + c) = total selling exp. ADMINISTRATIVE EXPENSES (a+ b+ c) = total admin. exp. (total selling expenses + total admin. expenses) = operating expenses Gross profit - operating expenses = income from operations

What is earnings management?

The planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings. Used to INCREASE income in the current year at the expense of income in future years. Used to DECREASE current earnings in order to increase income in the future.

Explain the transaction approach to measuring income. Why is the transaction approach to income measurement preferable to other ways of measuring income?

This approach focuses on the activities that have occurred during a given period and instead of presenting only a net change, a description of the components that comprise the change is included. In the capital maintenance approach, only the net change (income) is reflected whereas the transaction approach not only provides the net change (income) but the components of income (revenues and expenses). The final net income figure should be the same under either approach given the same valuation base.

How can information based on past transactions be used to predict future cashflows?

To identify important trends that, if continued, provide information about future performance. If a reasonable correlation exists between past and future performance, predictions about future earnings and cash flows can be made

Non controlling interest

When a company owns substantial interests (generally greater than 50%) in another company, GAAP generally requires that the financial statements of both companies be consolidated together into one set of financials

According to GAAP, which is recommended the modified all inclusive income statement or the current operating performance income statement?

a modified all-inclusive income statement, excluding from the income statement only those items, few in number, which meet the criteria for prior period adjustments and which would thus appear as adjustments to the beginning balance in the retained earnings statement. Subsequently a number of pronouncements have reinforced this position. Recently, changes in accounting principle are also adjusted through the beginning retained earnings balance.

Discontinued operations are reported:

after "income from continuing operations"

Comprehensive income

all changes in equity during a period except those resulting from investments by owners and distributions to owners.

Modified all inclusive concept

companies record most items, including unusual or infrequent ones,as part of net income.

Both GAAP and IFRS have items that are recognized in _____ as part of comprehensive income but do not affect net income. Both GAAP and IFRS allow a one statement or two statement approach to preparing the statement of comprehensive income.

equity

Non controlling interest is the portion of _______.

equity (net assets) interest in a subsidiary not attributable to the parent company.

Unusual

high degree of abnormality anode type clearly unrelated tom or only incidentally related to, the ordinary and typical activities of the company, taking into account the environment in which it operates.

IFRS identifies certain minimum items that should be presented on the_______. GAAP has no minimum information requirements. However, the SEC rules have more rigorous presentation requirements.

income statement.

Both GAAP and IFRS require companies to ___________ attributable to non controlling interest.

indicate the amount of net income

Revenues

inflows or other enhancements of assets or settlements of its liabilities that constitute the entity's ongoing major or central operations

Under IFRS, companies must classify expenses by either ____ or ____. GAAP does not have that requirement, but the SEC requires a functional presentation.

nature or function

Disadvantage of the One Statement Approach?

net income buried as a subtotal on the statement

Expenses

outflows or other using-up of assets or incurrences of liabilities that constitute the entity's ongoing major or central operations.

Under IFRS, revaluation of property, plant, and equipment, and intangible assets is _____, with gains reported as other comprehensive income. The effect of this difference is that application of IFRS results in more transactions affecting equity but not net income.

permitted

What does quality of earnings mean?

refers to the credibility of the earnings number reported

Presentation of the income statement under GAAP follows either a _____ or _____ format. IFRS does not mention a single-step or multiple-step approach.

single-step or multiple-step

Statement of Stockholders' Equity reports

the changes in each stockholders' equity account and total equity for the period.

What are the objectives of GAAP in their application to the income statement?

to measure and report the results of operations as they occur for a specified period without recognizing any artificial exclusions or modifications.

Infrequency of occurrence

type of transaction that is not reasonably expected to recur in the foreseeable future, taking into account the environment in which the company operates.

With the recent FASB Accounting Standards Update, under both IFRS and GAAP.....

unusual and infrequent income items are reported in Income before income taxes (i.e., not an extraordinary item treatment).

Which of the following is not reported in an income statement under IFRS? a. Discontinued operations. b. Extraordinary items. c. Cost of goods sold. d. Income tax.

b. extraordinary items

Which of the following statements is correct regarding income reporting under IFRS? a) IFRS does not permit revaluation of property, plant, and equipment, and intangible assets. b) IFRS provides the same options for reporting comprehensive income as GAAP. c) Companies must classify expenses either by nature or function. d) IFRS provides a definition for all items presented in the income statement.

c) companies must classify expenses either by nature or function

Discuss the appropriate treatment in the financial statements of each of the following: d) rent received from subletting a portion of the office space e) a patent infringement suit, brought 2 years ago against the company by another company, was settled this year by a cash payment of $725,000. f) a reduction in the allowance for doubtful accounts balance because the account appears to be considerable in excess of the probable loss from uncollectible receivable.

d) This should be shown in the income statement. One treatment would be to show it in the statement as a deduction from the rent expense, as it reduces an operating expense and therefore is directly related to operations. Another treatment is to show it in the other revenues and gains section of the income statement. (e) Assuming that a provision for the loss had not been made at the time the patent infringement suit was instituted, the loss should be recognized in the current period in computing net income. It should be reported as an unusual loss in the other expenses and losses section. (f) This should be reported in the income statement in the operating section because it relates to usual business operations of the company.

Losses

decreases in equity (net assets) from peripheral or incidental transactions

Restrictions on Retained earnings:

disclosed: -in notes to the financial statements -as Appropriate Retained Earnings

IFRS _____ define key measures like income from operations. SEC regulations define many key measures and provide requirements and limitations on companies reporting non-GAAP/ IFRS information.

does not

Advantage of the One Statement Approach?

does not require the creation of a new financial statement