Financial Analysis Notes PDF

**[Financial Analysis Notes]** **Chapter 1** **1. Financial Reporting Environment, Major Standard-Setting Bodies, and GAAP** **Financial Reporting Environment:** The objective of general-purpose financial reporting is to provide financial information that is useful to present and potential invest...

**[Financial Analysis Notes]** **Chapter 1** **1. Financial Reporting Environment, Major Standard-Setting Bodies, and GAAP** **Financial Reporting Environment:** The objective of general-purpose financial reporting is to provide financial information that is useful to present and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. **Major Standard-Setting Bodies:** - **Securities and Exchange Commission (SEC):** A federal agency with broad powers to prescribe accounting standards for companies under its jurisdiction. - **Financial Accounting Standards Board (FASB):** Establishes and improves standards of financial accounting and reporting for the guidance and education of the public. **Generally Accepted Accounting Principles (GAAP):** Principles that have substantial authoritative support and are documented, presented, and updated in the Codification to simplify user access to all authoritative GAAP. **2. Components and Usefulness of the Conceptual Framework** **Conceptual Framework:** Provides a foundation for setting accounting standards and solving new and emerging practical problems. It aims to enhance comparability among companies\' financial statements and increase users\' understanding and confidence in financial reporting. **Objective of Financial Reporting:** To provide financial information useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity. **Fundamental Qualities of Useful Information:** - **Relevance:** Information that makes a difference in decision-making with predictive or confirmatory value. - **Faithful Representation:** Information that is complete, neutral, and free from error. **Enhancing Qualities of Useful Information:** - **Comparability:** Enables users to identify similarities and differences between two sets of economic phenomena. - **Verifiability:** Assures users that information faithfully represents the economic phenomena it purports to represent. - **Timeliness:** Information is available to decision-makers in time to be capable of influencing their decisions. - **Understandability:** Information is classified, characterized, and presented clearly and concisely. **Elements of Financial Statements:** - **Assets, Liabilities, Equity, Investments by Owners, Distributions to Owners, Comprehensive Income, Revenues, Expenses, Gains, and Losses.** **3. Basic Assumptions and Principles of Accounting** **Basic Assumptions:** - **Economic Entity:** The activity of a company is kept separate and distinct from its owners and other business units. - **Going Concern:** The company will continue to operate for a foreseeable future. - **Monetary Unit:** Money is the common denominator for economic activity measurement and analysis. - **Periodicity:** The economic activities of a company can be divided into artificial time periods for reporting purposes. **Principles of Accounting:** - **Measurement Principle:** Use of historical cost, fair value, and other valuation bases for measurement. - **Revenue Recognition Principle:** Revenue is recognized when a performance obligation is satisfied. - **Expense Recognition Principle:** Expenses are recognized when they contribute to revenue (matching principle). - **Full Disclosure Principle:** Provide sufficient information to influence the judgment and decisions of an informed user. - **Cost Constraint:** Weigh the cost of providing information against the benefits derived from its use. **\ ** **4. Major Challenges in the Financial Reporting Environment** **Challenges:** - **User Groups Influence:** Different user groups may want specific economic events accounted for or reported in a particular way, often targeting the FASB for changes. - **Insufficient Reporting:** Financial reports may lack key performance measures, forward-looking information, sufficient information on intangibles, real-time information, and easy-to-understand information. - **Ethical Decision-Making:** Accountants must navigate moral discernment and ethical decisions without a comprehensive ethical system for guidance. **Vocabulary Definitions** **Accounting Standards Updates** Statements issued by the Financial Accounting Standards Board (FASB) to update the Accounting Standards Codification (ASC), including new accounting guidance or amendments to existing standards. **American Institute of Certified Public Accountants (AICPA)** A professional organization of Certified Public Accountants (CPAs) in the United States, which sets ethical standards and auditing standards for private companies, non-profit organizations, and government entities. **Financial Accounting Foundation (FAF)** An organization responsible for the oversight, administration, and finances of the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB). **Financial Accounting Standards Advisory Council (FASAC)** A council that advises the FASB on issues related to projects on the board's agenda, agenda decisions, and strategic direction. **Financial Accounting Standards Board (FASB)** The independent body responsible for establishing and improving financial accounting and reporting standards in the United States. **Financial Accounting Standards Board Accounting Standards Codification** The source of authoritative, non-governmental GAAP, organized by topic. **Financial Accounting Standards Board Codification Research System (CRS)** An online tool that provides access to the FASB Accounting Standards Codification and related research. **Generally Accepted Accounting Principles (GAAP)** The common set of accounting principles, standards, and procedures that companies use to compile their financial statements. **International Accounting Standards Board (IASB)** An independent body that develops and approves International Financial Reporting Standards (IFRS). **International Financial Reporting Standards (IFRS)** International accounting standards set by the IASB, intended to provide common financial reporting standards for global businesses. **Public Company Accounting Oversight Board (PCAOB)** A nonprofit organization established by the Sarbanes-Oxley Act to oversee the audits of public companies. **Securities and Exchange Commission (SEC)** A U.S. government agency that oversees securities transactions, activities of financial professionals, and the stock market to protect investors. **Statements of Financial Accounting Concepts (SFAC)** Publications by the FASB that outline the theoretical framework for financial accounting and reporting. **Qualitative Characteristics** **Assumptions** Basic premises on which financial accounting is based, including assumptions like economic entity, going concern, monetary unit, and periodicity. **Comparability** A qualitative characteristic of accounting information that allows users to identify similarities and differences between two sets of economic phenomena. **Completeness** A component of faithful representation, ensuring that all necessary information is included in financial reports for decision-making. **Conceptual Framework** A system of interrelated objectives and fundamentals that provides the foundation for the development of accounting standards. **Confirmatory Value** A characteristic of relevant information that helps users confirm or correct prior expectations. **Conservatism** An accounting principle where uncertainty and the risk of overestimating assets or income are accounted for by reporting lower values. **Consistency** A qualitative characteristic that ensures the same accounting methods are used from period to period. **Cost Constraint (Cost-Benefit Relationship)** The principle that the benefits derived from providing accounting information should exceed the cost of providing it. **Decision-Usefulness** The overall objective of financial reporting, which is to provide information that is useful for making economic decisions. **Due Process** The process by which accounting standards are developed, involving multiple stages of review, public input, and refinement. **Economic Entity Assumption** The principle that business transactions are separate from the transactions of the owner or other businesses. **Elements** The basic components of financial statements, including assets, liabilities, equity, revenues, expenses, gains, and losses. **Expectations Gap** The difference between what the public expects from the accounting profession and what the profession actually provides. **Expense Recognition Principle** The principle that expenses should be recognized in the same period as the revenues they help generate. **Fair Value** The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. **Fair Value Principle** The principle that assets and liabilities should be reported at their fair values. **Faithful Representation** A fundamental qualitative characteristic requiring that financial information be complete, neutral, and free from error. **Financial Reporting** The communication of financial information to external users. **Financial Statements** Structured reports that provide an overview of a company\'s financial position and performance, including the balance sheet, income statement, statement of cash flows, and statement of changes in equity. **Free from Error** A component of faithful representation, ensuring that information is accurate and free from material misstatements. **Full Disclosure Principle** The principle that all relevant information should be disclosed in financial statements to provide a complete picture of the company\'s financial position. **General-Purpose Financial Statements** Financial statements that are intended to meet the needs of a wide range of users. **Going Concern Assumption** The assumption that a business will continue to operate indefinitely, rather than being closed or sold. **Historical Cost Principle** The principle that assets should be recorded and reported at their original purchase price. **Materiality** The threshold for recognizing whether information is sufficiently significant to influence decisions made by users of financial statements. **Monetary Unit Assumption** The principle that only transaction data capable of being expressed in terms of money should be included in accounting records. **Neutrality** The principle that accounting information should be unbiased and impartial. **Notes to Financial Statements** Additional information provided in financial statements to help users understand the underlying details. **Objective of Financial Reporting** The primary goal of financial reporting is to provide information that is useful for decision-making. **Performance Obligation** A promise in a contract to provide a distinct good or service to a customer. **Period Costs** Costs that are taken directly to the income statement as expenses in the period in which they are incurred. **Periodicity (Time Period) Assumption** The principle that financial statements should be divided into artificial time periods for reporting purposes. **Predictive Value** A component of relevance, ensuring that information can help users make predictions about future events. **Principles** The fundamental concepts that underlie financial accounting and reporting practices. **Product Costs** Costs that are a necessary and integral part of producing the finished product. **Qualitative Characteristics** The attributes that make financial information useful to users. **Relevance** A fundamental qualitative characteristic that makes information capable of making a difference in decision-making. **Revenue Recognition Principle** The principle that revenue should be recognized when it is earned and realizable. **Sarbanes-Oxley Act** A law enacted to enhance corporate responsibility, enhance financial disclosures, and combat corporate and accounting fraud. **Supplementary Information** Additional information provided in financial statements beyond the basic financial statements themselves. **Timeliness** A characteristic of useful financial information that ensures information is available to decision-makers in time to influence their decisions. **Understandability** A qualitative characteristic that ensures financial information is comprehensible to users who have a reasonable knowledge of business and economic activities. **Verifiability** A component of faithful representation that ensures that different knowledgeable and independent observers can reach a consensus that a particular depiction is faithfully represented. Chapter 1 HW Part 1 1. **Quality of Information to Confirm or Correct Prior Expectations:** The quality is **confirmatory value**. 2. **Pervasive Constraint Developed in the Conceptual Framework:** The pervasive constraint is **cost constraint** (cost-benefit constraint). 3. **Qualitative Characteristic to Prevent Credibility Risk (Avoiding Faithful Representation):** The characteristic is **neutrality**. 4. **Muruyama Corp. Switches from FIFO to Average-Cost to FIFO Over a 2-Year Period:** The qualitative characteristic not followed is **consistency**. 5. **Savings and Loan Industry Defers Losses to Avoid Adverse Economic Consequences:** The characteristic not followed is **neutrality**. 6. **Two Fundamental Qualities that Make Accounting Information Useful for Decision-Making:** The fundamental qualities are **relevance** and **faithful representation**. 7. **Watteau Inc. Delays First-Quarter Report Until After the Second Quarter:** The characteristic not followed is **timeliness**. 8. **Predictive Value as an Ingredient of Fundamental Qualities:** Predictive value is an ingredient of **relevance**. 9. **Duggan, Inc. Depreciates Plant Assets Differently than Industry:** The characteristic may not be followed is **comparability**. 10. **Roddick Company Uses Middle Value of Appraisers for Replacement Cost:** The characteristic lacking in these data is **verifiability**. Part 2 1. **Arises from peripheral or incidental transactions:** Gains 2. **Obligation to transfer resources arising from a past transaction:** Liabilities 3. **Increases ownership interest:** Investments by owners 4. **Declares and pays cash dividends to owners:** Distributions to owners 5. **Increases in net assets in a period from nonowner sources:** Comprehensive income 6. **Items characterized by service potential or future economic benefit:** Assets 7. **Equals increase in assets less liabilities during the year, after adding distributions to owners and subtracting investments by owners:** Comprehensive income 8. **Arises from income statement activities that constitute the entity's ongoing major or central operations:** Revenues 9. **Residual interest in the assets of the enterprise after deducting its liabilities:** Equity 10. **Increases assets during a period through sale of product:** Revenues 11. **Decreases assets during the period by purchasing the company's own stock:** Distributions to owners 12. **Includes all changes in equity during the period, except those resulting from investments by owners and distributions to owners:** Comprehensive income Chapter 3 **Learning Objective 1: Uses, Limitations, and Content of an Income Statement** **Income Statement Overview:** - Measures company operations success over a period. - Also known as the statement of income or statement of earnings. - Used by the business and investment community to determine profitability, investment value, and creditworthiness. - Predicts future cash flows in terms of amounts, timing, and uncertainty. **Usefulness of the Income Statement:** 1. **Evaluate Past Performance:** - Examines revenues and expenses to compare performance with competitors (e.g., Ford vs. Toyota). 2. **Predict Future Performance:** - Past performance trends help predict future revenues, earnings, and cash flows (e.g., General Electric\'s consistent revenue increases in the past). 3. **Assess Risk or Uncertainty of Future Cash Flows:** - Highlights relationships among revenue, expenses, gains, and losses to assess the risk of achieving certain cash flow levels (e.g., IBM separating operating performance from non-recurring income sources). **Limitations of the Income Statement:** 1. **Omission of Items:** - Companies may omit items that cannot be measured reliably (e.g., unrealized gains/losses on investment securities, brand recognition, customer service). - Lack of a framework to identify and report such values. 2. **Effect of Accounting Methods:** - Different accounting methods (e.g., accelerated depreciation vs. straight-line depreciation) can affect income comparisons. 3. **Judgment in Income Measurement:** - Varies in asset life estimates, warranty costs, and bad debt estimations, leading to different income results. **Content of the Income Statement:** - **Revenues:** - Inflows or enhancements of assets or settlements of liabilities from delivering or producing goods, services, or other central operations. - **Expenses:** - Outflows or using-up of assets or incurrence of liabilities from delivering or producing goods, services, or other central operations. - **Gains:** - Increases in equity from peripheral or incidental transactions. - **Losses:** - Decreases in equity from peripheral or incidental transactions. **Income Measurement and Multiple-Step Income Statement** **Income Statement and Transaction Approach:** - Focuses on income-related activities during the period. - Can classify income by customer, product line, function, operating and non-operating, continuing and discontinued, and regular and non-recurring categories. **Multiple-Step vs. Single-Step Income Statement:** - **Multiple-Step Income Statement:** Shows several steps in determining net income. - Reports net sales, gross profit, income from operations, income before income tax, and net income. - Distinguishes operating from non-operating activities. **Components of Multiple-Step Income Statement:** 1. **Net Sales:** Represents regular and recurring revenue, crucial for long-term profitability. 2. **Gross Profit:** Derived by deducting cost of goods sold from net sales. Indicates merchandising profit, not overall profitability as operating expenses are not deducted. 3. **Operating Expenses:** Categorized into selling expenses and general and administrative expenses. 4. **Income from Operations:** Highlights core earnings from regular operations. 5. **Other Revenues and Gains:** Includes items like dividend revenue and gain on sale of non-operational assets. 6. **Other Expenses and Losses:** Includes items like interest on bonds and occasional losses from unusual events. 7. **Income Before Income Tax:** Derived by adding non-operating revenues and gains to income from operations, and subtracting non-operating expenses and losses. 8. **Net Income:** Represents earnings minus all related expenses, including taxes. **Important Concepts:** - **Unusual items:** High degree of abnormality, unrelated to ordinary activities. - **Infrequent items:** Transactions not expected to recur in the foreseeable future. **Income Measurement and Multiple-Step Income Statement** **Income Statement and Transaction Approach:** - Focuses on income-related activities during the period. - Can classify income by customer, product line, function, operating and non-operating, continuing and discontinued, and regular and non-recurring categories. **Multiple-Step vs. Single-Step Income Statement:** - **Multiple-Step Income Statement:** Shows several steps in determining net income. - Reports net sales, gross profit, income from operations, income before income tax, and net income. - Distinguishes operating from non-operating activities. **Components of Multiple-Step Income Statement:** 1. **Net Sales:** Represents regular and recurring revenue, crucial for long-term profitability. 2. **Gross Profit:** Derived by deducting cost of goods sold from net sales. Indicates merchandising profit, not overall profitability as operating expenses are not deducted. 3. **Operating Expenses:** Categorized into selling expenses and general and administrative expenses. 4. **Income from Operations:** Highlights core earnings from regular operations. 5. **Other Revenues and Gains:** Includes items like dividend revenue and gain on sale of non-operational assets. 6. **Other Expenses and Losses:** Includes items like interest on bonds and occasional losses from unusual events. 7. **Income Before Income Tax:** Derived by adding non-operating revenues and gains to income from operations, and subtracting non-operating expenses and losses. **Income Tax:** - Significant expense for many companies. - Analysts closely monitor the relationship of income tax to reported net income, considering factors such as loss carryovers from previous periods. **Net Income:** - Income tax expense is deducted to arrive at net income. - Focus for analysts to determine company success. Indicates market value as a present value of expected future profits but requires careful analysis. - Reporting components of net income helps predict future income and cash flows. **Earnings per Share (EPS):** - Measures dollars earned per share of common stock, not the dividends paid to stockholders. - **EPS Formula:** Earnings per Share(EPS)=Net Income−Preferred DividendsWeighted−Average Number of Common Shares OutstandingEarnings \\, per \\, Share (EPS) = \\frac{Net \\, Income - Preferred \\, Dividends}{Weighted-Average \\, Number \\, of \\, Common \\, Shares \\, Outstanding} - Important for assessing profitability per shareholder. **Important Concepts:** - **Unusual items:** High degree of abnormality, unrelated to ordinary activities. - **Infrequent items:** Transactions not expected to recur in the foreseeable future. **Income Measurement and Multiple-Step Income Statement** **Income Statement and Transaction Approach:** - Focuses on income-related activities during the period. - Can classify income by customer, product line, function, operating and non-operating, continuing and discontinued, and regular and non-recurring categories. **Multiple-Step vs. Single-Step Income Statement:** - **Multiple-Step Income Statement:** Shows several steps in determining net income. - Reports net sales, gross profit, income from operations, income before income tax, and net income. - Distinguishes operating from non-operating activities. - **Single-Step Income Statement:** Simplifies the process by using a single step of subtracting total expenses from total revenues to determine net income. **Components of Multiple-Step Income Statement:** 1. **Net Sales:** Represents regular and recurring revenue, crucial for long-term profitability. 2. **Gross Profit:** Derived by deducting cost of goods sold from net sales. Indicates merchandising profit, not overall profitability as operating expenses are not deducted. 3. **Operating Expenses:** Categorized into selling expenses and general and administrative expenses. 4. **Income from Operations:** Highlights core earnings from regular operations. 5. **Other Revenues and Gains:** Includes items like dividend revenue and gain on sale of non-operational assets. 6. **Other Expenses and Losses:** Includes items like interest on bonds and occasional losses from unusual events. 7. **Income Before Income Tax:** Derived by adding non-operating revenues and gains to income from operations, and subtracting non-operating expenses and losses. **Income Tax:** - Significant expense for many companies. - Analysts closely monitor the relationship of income tax to reported net income, considering factors such as loss carryovers from previous periods. **Net Income:** - Income tax expense is deducted to arrive at net income. - Focus for analysts to determine company success. Indicates market value as a present value of expected future profits but requires careful analysis. - Reporting components of net income helps predict future income and cash flows. **Earnings per Share (EPS):** - Measures dollars earned per share of common stock, not the dividends paid to stockholders. - **EPS Formula:** Earnings per Share(EPS)=Net Income−Preferred DividendsWeighted−Average Number of Common Shares OutstandingEarnings \\, per \\, Share (EPS) = \\frac{Net \\, Income - Preferred \\, Dividends}{Weighted-Average \\, Number \\, of \\, Common \\, Shares \\, Outstanding} - Important for assessing profitability per shareholder. **Important Concepts:** - **Unusual items:** High degree of abnormality, unrelated to ordinary activities. - **Infrequent items:** Transactions not expected to recur in the foreseeable future. **Analytics in Action: Income Statement Dashboards:** - Dashboards provide easy visuals of key metrics for users like investors, creditors, and managers. - **Common Dashboard Elements:** - Revenue Bar Graph - Net Income (Loss) Bar Graph - Pie Chart by Geographic Region - Annual Operating Income Trend Line Graph - Dashboards help track data from accounting systems and public reports in XBRL format. **Accounting Matters: Top Line or Bottom Line:** - Importance of components of income and bottom line. - Focus on revenue arises from market expectations. - Cutting costs may temporarily boost earnings but has limitations. **Reporting Special Income Items** **Learning Objective 2: Discuss the Accounting for Unusual Income Items** **Reporting Income Components:** - The accounting profession requires companies to record most items, including unusual or infrequent ones, as part of net income. - Consistent and comparable income reporting practices are crucial for providing useful information. - Companies must sometimes highlight specific items in the income statement to help users determine the long-run earning power of the company. **Discontinued Operations:** - A discontinued operation occurs when a company eliminates a component of the business that represents a strategic shift. - Includes elimination of a major line of business, geographical area, or major equity method investment. - Reported net of tax on the income statement (intraperiod tax allocation). **Intraperiod Tax Allocation:** - Allocation of tax expense within the income statement of a period. - Helps users understand the impact of income taxes on various components of net income. - Used for income from continuing operations and discontinued operations. - Associate a separate tax effect for discontinued operations. **Other Comprehensive Income:** - As the use of fair values for measuring assets and liabilities increases, reporting gains and losses related to these changes has become controversial. - Some gains and losses, such as unrealized gains and losses on available-for-sale debt investments, are excluded from net income to reduce volatility. - Reported in a measure called comprehensive income, which includes all changes in equity except those resulting from investments by owners and distributions to owners. - Comprehensive income includes net income and other comprehensive income (gains/losses that bypass net income but affect stockholders\' equity). **Display of Other Comprehensive Income:** - **One Statement Approach:** A single continuous statement called the statement of comprehensive income. - **Two Statement Approach:** Two separate but consecutive statements of net income and other comprehensive income (income statement and comprehensive income statement). - Under either approach, companies must display each component of net income and each component of other comprehensive income. **Important Concepts:** - **Discontinued Operations:** Results from eliminating a component with a strategic shift, reported net of tax. - **Intraperiod Tax Allocation:** Allocates tax expense within the income statement to specific items. - **Other Comprehensive Income:** Includes gains and losses that bypass net income but affect stockholders\' equity. **Stockholders' Equity Statements** **Learning Objective 3: Explain the Reporting of Stockholders' Equity** **Retained Earnings:** - **Impact on Retained Earnings:** - **Increases:** Net income. - **Decreases:** Net loss, cash dividends, and stock dividends. - Adjustments due to changes in accounting principles or corrections of errors, usually made net of tax. - **Presentation:** - Retained earnings information can be presented in various ways, such as a separate retained earnings statement. - The reconciliation of the beginning to ending balance provides insight into changes in retained earnings during the year. - **Management Decisions:** - Reflects management\'s decisions on earnings distribution vs. reinvestment. - Companies may \"plow back\" earnings into the business or distribute them. **Restrictions on Retained Earnings:** - Companies may restrict retained earnings to comply with contractual requirements, board policy, or current necessity. - Disclosure of restricted retained earnings amounts in the financial statement notes. - **Retained Earnings Account:** Reports both unrestricted (free) and restricted (appropriated) retained earnings. **Statement of Stockholders' Equity:** - Reports changes in each stockholders' equity account and the total stockholders' equity during the year. - **Stockholders' Equity Components:** - **Contributed Capital:** Common and preferred stock, additional paid-in capital. - **Retained Earnings:** Accumulated net income/deficit. - **Accumulated Other Comprehensive Income (AOCI):** Includes unrealized gains and losses excluded from net income. - **Format:** - Often prepared in a columnar format, with columns for each account and total stockholders' equity. - **Reporting:** - Ending balances from this statement are reported in the stockholders\' equity section of the balance sheet. - Provides comprehensive information about all changes in net assets, enhancing users\' understanding of the company\'s performance. **Expanded Topics:** **1. Appropriated Retained Earnings:** - Represents the portion of retained earnings restricted for a specific purpose. - Reported separate from unrestricted retained earnings on the balance sheet. - Examples of appropriations: Legal requirements, contracts, board decisions. **2. Comprehensive Income:** - Includes all changes in equity during a period except investments by owners and distributions to owners. - Encompasses net income and other comprehensive income. - **Components:** Unrealized gains/losses on available-for-sale securities, foreign currency translation adjustments, and pension plan gains/losses. - **Reporting Approaches:** - **One Statement Approach:** Single, continuous statement called the statement of comprehensive income. - **Two Statement Approach:** Two separate but consecutive statements---income statement and comprehensive income statement. - Companies display each component of net income and other comprehensive income, but do not report earnings per share for comprehensive income. **3. Intraperiod Tax Allocation:** - Associates tax expense with specific items on the income statement. - Helps users understand the tax impact on different income components. - Applied to: - **Income from Continuing Operations:** Tax expense related to regular business activities. - **Discontinued Operations:** Separate tax effect for disposed components, aiding in predicting future cash flows. **4. Other Comprehensive Income:** - Reflects gains/losses excluded from net income to reduce income volatility. - Common items: Unrealized gains/losses on available-for-sale investments. - Reported separately to provide clarity on recurring vs. non-recurring items. - Enhances transparency and decision-making for investors and creditors. **Revenue Recognition - The Fundamentals** **Learning Objective 4: Explain the Revenue Recognition Principle** **Revenue Recognition Principle:** - **Objective:** Recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration the company receives or expects to receive. - **Control:** The key factor in recognizing revenue is when the customer gains control of the product or service. - **Change in Control Indicators:** - Right to payment. - Transfer of legal title. - Transfer of physical possession. - Customer has significant risks and rewards of ownership. - Customer acceptance of the asset. **Overview of the Five-Step Model for Revenue Recognition:** **Revenue Recognition: In-Depth Five-Step Model** **Step 1: Identify the Contract** **Definition: A contract is an agreement that creates enforceable rights and obligations between two or more parties.** **Characteristics:** - **Explicit or Implied: Contracts can be formal written documents, verbal agreements, or implied through customary business practices.** - **Criteria for Validity:** - **Approval and Commitment: Both parties must approve and commit to the contract.** - **Identification of Rights and Payment Terms: The agreement must clearly identify the rights of each party and the payment terms.** - **Commercial Substance: The contract must represent a valid transaction with real economic impact.** - **Collection Probability: It must be probable that the consideration will be collected.** **Examples:** - **Retail Sales: If you buy a product off the shelf, an implied contract exists between you and the store.** - **Service Contracts: A formal written contract for cloud-based services defining capacity utilization and terms.** **Step 2: Identify Performance Obligations** **Definition: A performance obligation is a promise within a contract to transfer a distinct good or service to the customer.** **Characteristics:** - **Distinct Goods or Services: Goods or services that are separately identifiable and provide individual value to the customer.** - **Separate Recording: Each distinct performance obligation should be recorded separately if they are material and identifiable.** **Considerations:** - **Bundles: Sometimes contracts include bundles of goods/services, which can complicate identification.** - **Separate vs. Combined: Determine if goods/services are distinct within the context of the contract or should be combined.** **Examples:** - **Single Obligation: Delivering a product.** - **Multiple Obligations: Providing a product along with installation services.** **Step 3: Determine the Transaction Price** **Definition: The transaction price is the amount of consideration a company expects to receive in exchange for transferring goods or services.** **Factors to Consider:** - **Variable Consideration: Adjustments for potential price changes due to discounts, rebates, or penalties.** - **Significant Financing Component: Adjusting for the time value of money if payment timing significantly affects the transaction price.** - **Non-Cash Consideration: Including the fair value of non-cash compensation such as stocks or barter goods.** - **Consideration Payable to a Customer: Any payments back to the customer are factored in.** **Challenges:** - **Estimation: Estimating variable consideration and ensuring it reflects likely amounts without significant reversal.** - **Adjustments: Regularly reassessing the transaction price as circumstances change.** **Examples:** - **Fixed Price: Straightforward determination, e.g., selling a product for \$100.** - **Variable Price: Involving future adjustments based on performance incentives or penalties.** **Step 4: Allocate the Transaction Price to Performance Obligations** **Definition: Allocate the transaction price to each performance obligation based on its relative standalone selling price.** **Methods for Estimating Standalone Selling Prices:** - **Adjusted Market Assessment Approach: Based on market prices for similar goods/services.** - **Expected Cost Plus Margin Approach: Calculating expected costs and adding a reasonable margin.** - **Residual Approach: Subtracting the known standalone selling prices of other goods/services from the total transaction price.** **Considerations:** - **Multiple Performance Obligations: Allocating the price proportionately based on standalone selling prices.** - **Discounts and Variable Consideration: Appropriately allocated to performance obligations.** **Examples:** - **Single Product Sales: Easy allocation if only one obligation exists.** - **Combination Sales: Allocating prices when selling a bundle of products/services.** **Step 5: Recognize Revenue When (or As) Performance Obligation is Satisfied** **Definition: Recognize revenue when control of the goods or services transfers to the customer.** **Indicators of Control Transfer:** - **Transfer of Risks and Rewards: Customer assumes significant risks and rewards of ownership.** - **Legal Title Transfer: When legal ownership passes to the customer.** - **Physical Possession Transfer: Customer gains physical access to the product.** - **Customer Acceptance: The customer accepts the product/service delivered.** **Considerations:** - **Point in Time vs. Over Time: Determining whether revenue should be recognized at a single point in time or over the contract\'s duration.** - **Partial Fulfillment: Accounting for revenue based on partial satisfaction of performance obligations.** **Examples:** - **At Delivery: Recognizing revenue when a product is delivered to the customer.** - **Service Contracts: Recognizing revenue progressively as services are rendered over time.** **Expanded Topics:** **1. Variable Consideration:** - **Definition:** Estimated amount of variable consideration included in the transaction price. - Factors include discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, and penalties. - **Constraint:** Revenue is recognized only to the extent it is probable that significant reversal will not occur. **2. Significant Financing Component:** - **Definition:** Adjustment of the transaction price for the time value of money if there is a significant financing component. - **Factors:** - The difference between the amount of promised consideration and the cash selling price. - The combined effect of the expected length of time between the transfer of goods or services and the receipt of payment. - The prevailing interest rates in the relevant market. **3. Non-Cash Consideration:** - **Definition:** Transaction price includes the fair value of non-cash consideration received from the customer. - **Examples:** Shares, equipment, or barter transactions. **4. Contract Modifications:** - Adjustments required when contracts are modified. - Modifications treated as separate contracts or as part of the existing contract based on certain criteria. - **Criteria:** - Addition of distinct goods or services. - Increase in the contract price reflecting standalone selling prices. **5. Presentation and Disclosure:** - **Presentation:** Revenue recognized and not recognized is separated clearly on the financial statements. - **Disclosure Requirements:** Detailed information about contracts, significant judgments, and changes in judgments **Earnings Quality** **Learning Objective 5: Describe the Concept of Earnings Quality** **Importance of Earnings Quality:** - Earnings quality is crucial for making informed investment and credit decisions. - Firms aim to meet or surpass Wall Street expectations to boost stock prices and the value of management's stock compensation. - Companies sometimes "manage" earnings to meet targets or reduce perceived riskiness, risking the quality of earnings and financial reporting integrity. **Earnings Management:** - **Definition:** The planned timing of revenues, expenses, gains, and losses to smooth earnings over time. - **Purpose:** Often to increase current year's income at the expense of future income, or to create reserves to enhance future earnings. - **Consequences:** Dilutes the reliability of financial information, making it less useful for predicting future earnings and cash flows. **Examples of Earnings Management:** - **Hertz:** Charged with fraudulent financial reporting for artificially lowering bad debt expenses to meet earnings targets. - **Cookie Jar Reserves:** Creating reserves based on unrealistic assumptions to boost future earnings by reducing those reserves. - **Operating Performance Misrepresentation:** Misclassifying non-recurring gains or losses to influence operating income. **Non-GAAP Reporting:** - **Purpose:** To present financial results in a favorable light beyond generally accepted accounting principles (GAAP). - **Example - Groupon:** - **Income from Continuing Operations:** Loss of \$14,292 in 2019 as compared to a profit of \$1,988 in 2018. - **Adjustments for Non-GAAP Reporting:** - Stock-based compensation - Depreciation and amortization - Acquisition-related expenses - Restructuring charges - IBM patent litigation costs - Other income/expense adjustments - Provision for income taxes - **Adjusted EBITDA:** Adjusted income is \$227,248 in 2019 and \$269,807 in 2018 after these adjustments. **SEC Concerns:** - The SEC has expressed concerns that pressures to meet earnings targets could lead to manipulative practices, thus eroding the quality of earnings. **Improving Earnings Quality:** - **Transparency:** Detailed and accurate disclosure of earnings components, adjustments, and financial metrics. - **Judgment and Integrity:** Companies should exercise judgment responsibly and uphold integrity in financial reporting. - **Regulatory Oversight:** Enhanced oversight by regulatory bodies to enforce standards and disclose practices. **Quality of Earnings** **Learning Objective 5: Describe the Concept of Earnings Quality** **Importance of Earnings Quality:** - Essential for informed investment and credit decisions. - High earnings quality indicates reliable and sustainable earnings, providing a true reflection of the company\'s financial health. - Low earnings quality raises concerns about earnings manipulation and the long-term viability of reported profits. **Earnings Management** **Definition:** - The deliberate timing of revenues, expenses, gains, and losses to achieve specific financial outcomes, often to smooth earnings over time. **Purpose:** - Increase current year\'s income, sometimes at the expense of future earnings. - Create reserves (\"cookie jar reserves\") to manipulate future earnings. - Meet or beat earnings targets to influence stock prices and executive compensation. **Consequences:** - Dilutes the reliability of financial information. - Makes financial data less useful for predicting future earnings and cash flows. - Can lead to fraudulent financial reporting if pushed too far. **Non-GAAP Reporting** **Definition:** - Adjusted income numbers that exclude certain items to present results in a favorable light. **Purpose:** - Provide better insight into the fundamental operations of the business. - Present financial information in a way that management believes reflects the true economic performance of the company. **Concerns:** - Lack of standardization makes it difficult to compare across companies. - Can lead to inflated or misleading financial results. - Subject to scrutiny by regulatory bodies like the SEC. **Fraudulent Financial Reporting** **Definition:** - Intentional or reckless conduct that results in materially misleading financial statements. **Motivations:** - Influence stock prices. - Meet earnings benchmarks. - Influence executive compensation. - Protect individual careers. **Examples:** - Fictitious sales invoices. - Misapplication of accounting principles. - Failure to disclose material transactions. **Environmental Influences:** - Poor internal control systems. - Management\'s attitude towards ethics. - Significant liquidity or profitability problems. - Business environment factors (e.g., economic crises, pandemics). **Response by the Profession** **Sarbanes-Oxley Act (SOX):** - Passed to reduce unethical corporate behavior and enhance the accuracy of financial information. - Requires top management to certify financial information accuracy. - Imposes severe penalties for fraudulent financial reporting. **Regulation G (SEC):** - Requires companies to reconcile non-GAAP financial measures to GAAP. - Provides investors with a roadmap to analyze adjustments and compare non-GAAP measures across companies. **Data Analytics:** - SEC uses data analytics to identify potential violations and uncover earnings management practices. - Risk-based analytic approach helps maintain the quality and integrity of financial reporting.