Intermediate Accounting Chapter 24 PDF

Intermediate Accounting Seventeenth Edition Kieso; Weygandt; Warfield Chapter 24 Full Disclosure in Financial Reporting This slide deck contains animations. Please disable animations if they cause issues with your device. Learning Objectives...

Intermediate Accounting Seventeenth Edition Kieso; Weygandt; Warfield Chapter 24 Full Disclosure in Financial Reporting This slide deck contains animations. Please disable animations if they cause issues with your device. Learning Objectives After studying this chapter, you should be able to: 1. Review the full disclosure principle and describe how it is implemented. 2. Discuss the disclosure requirements for related-party transactions, post-balance-sheet events, major business segments, and interim reporting. 3. Identify the major disclosures in the auditor’s report and understand management’s responsibilities for the financial statements. 4. Identify reporting issues related to fraudulent financial reporting and financial forecasts. Copyright ©2019 John Wiley & Sons, Inc. 2 Preview of Chapter 24 Full Disclosure In Financial Reporting Full Disclosure Principle Increase in reporting requirements Differential disclosure Notes to the financial statements Disclosure Issues Related parties Post-balance-sheet events Diversified companies Interim reports Copyright ©2019 John Wiley & Sons, Inc. 3 Preview of Chapter 24 (continued) Auditor's and Management’s Reports Auditor's report Management's reports Current Reporting Issues Fraudulent financial reporting Internet financial reporting Reporting on forecasts and projections Criteria for accounting and reporting choices Copyright ©2019 John Wiley & Sons, Inc. 4 Learning Objective 1 Review the Full Disclosure Principle and Describe How It Is Implemented LO 1 Copyright ©2019 John Wiley & Sons, Inc. 5 Full Disclosure Principle Full disclosure principle calls for financial reporting of any financial facts significant enough to influence the judgment of an informed reader. Financial disasters at Microstrategy, PharMor, WorldCom, and Theranos highlight the difficulty of implementing the full disclosure principle. LO 1 Copyright ©2019 John Wiley & Sons, Inc. 6 Full Disclosure Principle Types of Financial Information LO 1 Copyright ©2019 John Wiley & Sons, Inc. 7 Full Disclosure Principle Increase in Reporting Requirements Reasons: Complexity of 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. LO 1 Copyright ©2019 John Wiley & Sons, Inc. 8  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 enhanced fair value and sustainability disclosures 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 Copyright ©2019 John Wiley & Sons, Inc. 9 Full Disclosure Principle Differential Disclosure “Big GAAP versus Little GAAP.” FASB has traditionally taken the position that there should be one set of GAAP. FASB is working with an advisory committee to explore ways that its standards can be more cost-effective for all companies, regardless of size. LO 1 Copyright ©2019 John Wiley & Sons, Inc. 10 Notes to the Financial Statements Notes are the means of amplifying or explaining the items presented in the main body of the statements. Accounting Policies Companies should present a statement identifying the accounting policies adopted and followed. Should present the disclosure as first note or separate Summary of Significant Accounting Policies section preceding the notes to the financial statements. LO 1 Copyright ©2019 John Wiley & Sons, Inc. 11 Notes to the Financial Statements Review Question Which of the following should be disclosed in a Summary of Significant Accounting Policies? a. Types of executory contracts. b. Amount for cumulative effect of change in accounting principle. c. Claims of equity holders. d. Depreciation method followed. LO 1 Copyright ©2019 John Wiley & Sons, Inc. 12 Notes to the Financial Statements Review Question - Answer Which of the following should be disclosed in a Summary of Significant Accounting Policies? a. Types of executory contracts. b. Amount for cumulative effect of change in accounting principle. c. Claims of equity holders. d. Answer: Depreciation method followed. LO 1 Copyright ©2019 John Wiley & Sons, Inc. 13 Notes to the Financial Statements Major Disclosures Common Notes 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). LO 1 Copyright ©2019 John Wiley & Sons, Inc. 14  Property, Plant, and Equipment : Companies should state the basis of valuation for property, plant, and equipment. 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. Copyright ©2019 John Wiley & Sons, Inc. 15  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. Equityholders’ 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 data in a note. Copyright ©2019 John Wiley & Sons, Inc. 16  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. Copyright ©2019 John Wiley & Sons, Inc. 17  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. Revenue. Users carefully review revenue disclosures to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. Deferred Taxes, Pensions, and Leases: The FASB also requires extensive disclosure in the areas of deferred taxes, pensions, and leases. Changes in Accounting Principles Copyright ©2019 John Wiley & Sons, Inc. 18 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 Copyright ©2019 John Wiley & Sons, Inc. 19 Learning Objective 3 Identify the Major Disclosures in the Auditor’s Report and Understand Management’s Responsibilities for the Financial Statements LO 3 Copyright ©2019 John Wiley & Sons, Inc. 20 Auditor’s and Management’s Reports Unqualified Opinion Auditor’s Report Unqualified Opinion – auditor expresses the opinion that the financial statements are presented fairly in accordance with GAAP. Other opinions: Qualified Adverse Disclaim LO 3 Copyright ©2019 John Wiley & Sons, Inc. 21 Auditor’s and Management’s Reports Explanatory Paragraph Auditor’s Report Certain circumstances, although they do not affect the auditor’s unqualified opinion, may require the auditor to add an explanatory paragraph to the audit report. Going Concern Lack of Consistency Emphasis of a Matter LO 3 Copyright ©2019 John Wiley & Sons, Inc. 22 Auditor’s and Management’s Reports Qualified Opinion Auditor’s Report Qualified opinion contains an exception to the standard opinion. Usual circumstances may include: 1. Scope limitation. 2. Statements do not fairly present financial position or results of operations because of: a. Lack of conformity with GAAP. b. Inadequate disclosure. LO 3 Copyright ©2019 John Wiley & Sons, Inc. 23 Auditor’s and Management’s Reports Adverse Opinion Auditor’s Report Adverse opinion is required in any report in which the exceptions to fair presentation are so material that in the independent auditor’s judgment, a qualified opinion is not justified. 1. The financial statements taken as a whole are not in accordance with GAAP a. Adverse opinions are rare. b. The SEC will not permit a company listed on an exchange to have an adverse opinion. LO 3 Copyright ©2019 John Wiley & Sons, Inc. 24 Auditor’s and Management’s Reports Disclaimer of an Opinion Auditor’s Report Disclaimer of an opinion is appropriate when the auditor has gathered so little information on the financial statements that no opinion can be expressed. LO 3 Copyright ©2019 John Wiley & Sons, Inc. 25 Auditor’s and Management’s Reports MD&A Management’s Report Management’s Discussion and Analysis The SEC mandates inclusion of management’s discussion and analysis (MD&A). Management highlights favorable or unfavorable trends related to liquidity, capital resources, and results of operations and identifies significant events and uncertainties that affect these three factors. LO 3 Copyright ©2019 John Wiley & Sons, Inc. 26 Auditor’s and Management’s Reports PepsiCo Inc. Example LO 3 Copyright ©2019 John Wiley & Sons, Inc. 27 Auditor’s and Management’s Reports Review Question The MD&A section of a company's annual report is to cover the following three items: a. income statement, balance sheet, and statement of owners' equity. b. income statement, balance sheet, and statement of cash flows. c. liquidity, capital resources, and results of operations. d. changes in the stock price, mergers, and acquisitions. LO 3 Copyright ©2019 John Wiley & Sons, Inc. 28 Auditor’s and Management’s Reports Review Question - Answer The MD&A section of a company's annual report is to cover the following three items: a. income statement, balance sheet, and statement of owners' equity. b. income statement, balance sheet, and statement of cash flows. c. Answer: liquidity, capital resources, and results of operations. d. changes in the stock price, mergers, and acquisitions. LO 3 Copyright ©2019 John Wiley & Sons, Inc. 29 Auditor’s and Management’s Reports Management’s Responsibilities Management’s Responsibilities for Financial Statements The Sarbanes-Oxley Act requires the SEC to develop guidelines for all publicly traded companies to report on management’s responsibilities for, and assessment of, the internal control system. LO 3 Copyright ©2019 John Wiley & Sons, Inc. 30 Auditor’s and Management’s Reports Home Depot Example LO 3 Copyright ©2019 John Wiley & Sons, Inc. 31 Learning Objective 5 Describe the Approach to Financial Statement Analysis LO 5 Copyright ©2019 John Wiley & Sons, Inc. 32 Appendix 24A: Perspective on Financial Statement Analysis (1 of 2) Perspective on Financial Statement Analysis A logical approach to financial statement analysis is necessary, consisting of the following steps. 1. Know the questions for which you want to find answers. 2. Know the questions that particular ratios and comparisons are able to help answer. 3. Match 1 and 2 above. By such a matching, the statement analysis will have a logical direction and purpose. LO 5 Copyright ©2019 John Wiley & Sons, Inc. 33 Appendix 24A: Perspective on Financial Statement Analysis (2 of 2) Analysis includes an understanding that 1. Financial statements report on the past. 2. Single ratio by itself is not likely to be very useful. 3. Awareness of the limitations of accounting numbers used in an analysis. LO 5 Copyright ©2019 John Wiley & Sons, Inc. 34 Learning Objective 6 Identify Major Analytic Ratios and Describe Their Calculation LO 6 Copyright ©2019 John Wiley & Sons, Inc. 35 In analyzing financial statement data, analysts use various devices to bring out the comparative and relative significance of the financial information presented. These devices include ratio analysis, comparative analysis, percentage analysis, and examination of related data. No one device is more useful than another. Every situation is different, and analysts often obtain the needed answers only upon close examination of the interrelationships among all the data provided. Ratio analysis is the starting point Copyright ©2019 John Wiley & Sons, Inc. 36 Appendix 24A: Ratio Analysis Major Types of Ratios Liquidity Ratios. Measures of the company's short-run ability to pay its maturing obligations. Activity Ratios. Measures of how effectively the company is using the assets employed. Profitability Ratios. Measures of the degree of success or failure of a given company or division for a given period of time. Coverage Ratios. Measures of the degree of protection for long- term creditors and investors. LO 6 Copyright ©2019 John Wiley & Sons, Inc. 37 Appendix 24A: Ratio Analysis Liquidity Ratio Formula for computation I. Liquidity Current assets 1. Current ratio Current liabilities 2. Quick or acid-test ratio Cash+Short-term investments + Accounts receivable (net) Current liabilities Net cash provided by 3. Current cash debt coverage operating activities Average current liabilities LO 6 Copyright ©2019 John Wiley & Sons, Inc. 38 Appendix 24A: Ratio Analysis Activity Ratio Formula for Computation II. Activity 4. Accounts receivable Net sales turnover Average net accounts receivable 5. Inventory turnover Cost of goods sold Average inventory 6. Asset turnover Net sales Average total assets LO 6 Copyright ©2019 John Wiley & Sons, Inc. 39 Appendix 24A: Ratio Analysis Profitability SUMMARY OF RATIOS PRESENTED IN EARLIER CHAPTERS Ratio Formula for computation III. Profitability Net income 7. Profit margin on sales Net sales 8. Return on assets Net income Average total assets 9. Return on common Net income minus preferred dividends Average common stockholders' equity stockholders’ equity Net income minus preferred dividends 10. Earnings per share Weighted-average common shares outstanding 11. Payout ratio Cash dividends Net income LO 6 Copyright ©2019 John Wiley & Sons, Inc. 40 Appendix 24A: Ratio Analysis Coverage Ratio Formula for computation IV. Coverage Total liabilities 12. Debt to assets ratio Total assets Net income + 13. Times interest earned Interest expense + Income tax expense Interest expense Net cash provided by 14. Cash debt coverage operating activities Average total liabilities 15. Book value per share Common stockholders' equity Outstanding shares LO 6 Copyright ©2019 John Wiley & Sons, Inc. 41 Learning Objective 7 Explain the Limitations of Ratio Analysis LO 7 Copyright ©2019 John Wiley & Sons, Inc. 42 Appendix 24A: Basic Financial Statement Analysis Limitation of Ratio Analysis Based on historical cost. Use of estimates. Achieving comparability among firms in a given industry. Substantial amount of important information is not included in a company’s financial statements. LO 7 Copyright ©2019 John Wiley & Sons, Inc. 43 Learning Objective 8 Describe Techniques of Comparative Analysis LO 8 Copyright ©2019 John Wiley & Sons, Inc. 44 Comparative analysis presents the same information for two or more different dates or periods, so that like items may be compared. Ratio analysis provides only a single snapshot, for one given point or period in time. In a comparative analysis, an investment analyst can concentrate on a given item and determine whether it appears to be growing or diminishing year by year and the proportion of such change to related items. Generally, companies present comparative financial statements. They typically include two years of balance sheet information and three years of income statement information. Copyright ©2019 John Wiley & Sons, Inc. 45  Appendix 24A: Comparative Analysis Anetek Chemical Corporation Condensed Comparative Statements (000,000 omitted) 10 years 20 years 2020 2019 2018 2010 2011 Ago 2010 Ago 2000 Sales and other revenue: Net sales $1,600.0 $1,350.0 $1,309.7 $1,176.2 $1,077.5 $636.2 $170.7 Other revenue 75.0 50.0 39.4 34.1 24.6 9.0 3.7 Total 1,675.0 1,400.0 1,349.1 1,210.3 1,102.1 645.2 174.4 Costs and other charges: Cost of sales 1,000.0 850.0 827.4 737.6 684.2 386.8 111.0 Depreciation and amortization 150.0 150.0 122.6 115.6 98.7 82.4 14.2 Selling and administrative expenses 225.0 150.0 144.2 133.7 126.7 66.7 10.7 Interest expense 50.0 25.0 28.5 20.7 9.4 8.9 1.8 Income taxes 100.0 75.0 79.5 73.5 68.3 42.4 12.4 Total 1,525.0 1,250.0 1,202.2 1,081.1 987.3 587.2 150.1 Net income for the year $ 150.0 $ 150.0 $ 146.9 $ 129.2 $ 114.8 $ 58.0 $ 24.3 LO 8 Copyright ©2019 John Wiley & Sons, Inc. 46 Learning Objective 9 Describe Techniques of Percentage Analysis LO 9 Copyright ©2019 John Wiley & Sons, Inc. 47 This approach, normally called horizontal analysis, indicates the proportionate change over a period of time. It is especially useful in evaluating trends, because absolute changes are often deceiving. Copyright ©2019 John Wiley & Sons, Inc. 48 Appendix 24A: Basic Financial Statement Analysis Percentage (Common Size) Analysis Anetek Chemical Corporation Horizontal Comparative Analysis (000,000 omitted) % Change 2020 2019 Difference Inc.(Dec.) Cost of sales $1,000.0 $850.0 $150.0 17.6% Depreciation and amortization 150.0 150.0 0 0 Selling and administrative expenses 225.0 150.0 75.0 50.0 Interest expense 50.0 25.0 25.0 100.0 Income taxes 100.0 75.0 25.0 33.3 LO 9 Copyright ©2019 John Wiley & Sons, Inc. 49 Another comparative approach, called vertical analysis, is the proportional expression of each financial statement item in a given period to a base figure. Copyright ©2019 John Wiley & Sons, Inc. 50 Appendix 24A: Basic Financial Statement Analysis Common Size Analysis – Income Statement ANETEK CHEMICAL CORPORATION INCOME STATEMENT (000,000 omitted) Amount Percentage of Total Revenue Net sales $1,600.0 96% Other revenue 75.0 4 Total revenue 1,675.0 100 Less: Cost of sales 1,000.0 60 Depreciation and amortization 150.0 9 Selling and administrative expenses 225.0 13 Interest expense 50.0 3 Income taxes 100.0 6 Total expenses 1,525.0 91 Net income $ 150.0 9% LO 9 Copyright ©2019 John Wiley & Sons, Inc. 51 Copyright Copyright © 2019 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. Copyright ©2019 John Wiley & Sons, Inc. 52