Module 28 Revenue Recognition PDF

**MODULE 28.1: REVENUE RECOGNITION**   **Cash Sales**: Revenue is recognized at the **time of exchange** when goods or services are sold for **cash**, and no **returns** are allowed. **Credit Sales**: Revenue is recognized at the **time of sale**, and an **asset** (**accounts receivable**) is cre...

**MODULE 28.1: REVENUE RECOGNITION**   **Cash Sales**: Revenue is recognized at the **time of exchange** when goods or services are sold for **cash**, and no **returns** are allowed. **Credit Sales**: Revenue is recognized at the **time of sale**, and an **asset** (**accounts receivable**) is created on the balance sheet. **Revenue Recognition**: Revenue is recognized in the period when it is **earned**, which may not necessarily be the same as the period in which **cash** is collected. **Revenue Reporting**: Revenue is reported **net** of any **returns** and **allowances**, such as **estimated warranty provisions** and **customer discounts**, on the **income statement**.   This principle of recognizing **revenue** when **earned**, regardless of **cash collection**, is foundational in **financial reporting**. It emphasizes the importance of matching **revenue** with the related period of **delivery** or **service**, rather than the timing of **payment**.     When **payment** is received before the transfer of goods or services, a **liability** called **unearned revenue** is created. This **offsets** the increase in the **asset** (**cash**). **Revenue** is recognized as the goods or services are **transferred** to the buyer. For example, in a **magazine subscription**: An **unearned revenue liability** is created when the subscription is purchased. As the **magazine issues** are delivered, **revenue** is recorded, and the **liability** decreases. This ensures **revenue** is recognized in the period goods/services are provided, not when payment is received. \"The **revenue recognition principle** is aligned with the **accrual accounting** principle. Both emphasize recognizing **revenue** when it is **earned**, not when **cash** is received.\"       \" **Converged standards** refer to the efforts by the **International Accounting Standards Board (IASB)**, which develops **International Financial Reporting Standards (IFRS)**, and the **Financial Accounting Standards Board (FASB)**, which develops **U.S. Generally Accepted Accounting Principles (U.S. GAAP)**, to align their accounting rules. The goal is to make **global financial reporting** more **consistent** and **comparable** across countries and industries. This convergence has led to the adoption of common principles in areas like **revenue recognition**.\"   The converged standards identify a five-step process1 for recognizing revenue: **Identify contract(s)** **Identify performance obligations** **Determine transaction price** **Allocate transaction price** **Recognize revenue**     **1 Identify contract** The standard defines a contract as an agreement between two or more parties that specifies their obligations and rights. Collectability must be probable for a contract to exist, but probable is defined differently under IFRS and U.S. GAAP, so an identical activity could still be accounted for differently by IFRS and U.S. GAAP reporting firms     2 A **performance obligation** is a promise to deliver a **distinct good or service**. A good or service is considered **distinct** if it meets these criteria: The customer can **benefit** from it on its own or with other readily available resources. **Bicycle** is distinct because the customer can use it on its own or add a **helmet** (readily available resource) for extra safety.   The promise to transfer the good or service can be **separately identified** from other promises. A **performance obligation** is a clear and separate promise. For example: **Phone** = one promise. **Phone insurance** = another promise. Each promise is treated separately, and the customer can choose one or both.   3 **Transaction Price:** The amount a company expects to receive for delivering a good or service. It can be **fixed** or **variable** (e.g., bonuses for early delivery). **Revenue Recognition:** Revenue is recognized only when it is **highly probable** it won't be reversed. If revenue is uncertain, the company records: A **liability** for potential refunds. An **asset** for goods expected to be returned. **Example** Imagine a store sells 50 phones for \$200 each but has a return policy that allows customers to return the phones within 30 days. If the store thinks 5 phones will be returned: It **cannot recognize all \$10,000 (\$200 × 50) as revenue immediately** because it knows some customers might return the phones. Instead, it records: A **liability** for \$1,000 (\$200 × 5) to cover potential refunds. An **asset** representing the 5 phones it expects to get back, which can be resold later.   **4 Allocate transaction price** **Recognizing Revenue on Transfer of Control** A firm **recognizes revenue** when the **performance obligation** is satisfied by **transferring control** of the good or service to the buyer. **Indicators** of control transfer include: **Physical possession** by the customer. **Acceptance** of the good or service. The customer **takes on risks and benefits** of ownership. The customer holds **legal title**. The seller has a **right to payment**.   **Recognizing Revenue for Long-Term Contracts** For **long-term contracts**, revenue is recognized based on the **firm's progress** toward completing the performance obligation. Progress can be measured using: **Input methods**: Based on **costs incurred** as a percentage of total estimated costs. **Output methods**: Based on **milestones achieved** or the **percentage of work completed**. Example: If 50% of the work is completed on a 2-year project, the firm recognizes 50% of the revenue in the first year.   **5 Recognize revenue Performance Obligations Over Time**   **1. Customer Benefits Over Time** **Meaning**: The customer gains value as the service or product is provided continuously over time. **Criteria**: Customer benefits **during** the service. Value is delivered **step-by-step** as the supplier works. **Example**: Cleaning services or regular car maintenance (value is received throughout the contract, not just at the end). **2. Enhancing or Creating Customer Assets** **Meaning**: The supplier is either improving something the customer already owns or building something new for the customer while the customer **owns or controls** the asset during the process. **Example**: **House construction**: The customer owns the land, and the builder improves it. **Car customization**: The customer owns the car and the supplier enhances it. **3. No Alternative Use with Enforceable Rights** **Meaning**: The asset is **custom-made** for the customer and has **no alternative use** for the supplier. The supplier can enforce payment for work done, even if the customer cancels the project early. **Example**: **Custom machinery**: A machine built specifically for one business and cannot be used by others. **Custom furniture**: A dining table designed uniquely for a customer and cannot be resold.           **Costs to Secure a Long-Term Contract** For long-term contracts, costs directly related to securing the contract, such as sales commissions, must be **capitalized**. This means the costs are recorded as assets and then **amortized** over the life of the contract. Instead of expensingthem all at once, the expense is spread out evenly over the duration of the contract.   This approach ensures that the costs to secure the contract are matched with the revenue generated from the contract, following the **matching principle** in accounting.     **Long-term contract costs** like **sales commissions** must be **capitalized**. These costs are then **amortized** over the contract\'s duration. **Amortization** means spreading the cost over time. Follows the **matching principle**: match costs with the **revenue** they help generate. Ensures expenses are recognized in the same period as related revenues.   **Performance obligation and progress toward completion (long-term contracts)** **Contract**: \$10 million to build a warehouse with \$8 million estimated costs. **Year 1**: Spends \$4 million (50% of costs), so 50% of \$10 million (\$5 million) is recognized as revenue. **Year 2**: Spends \$2 million more (total \$6 million, 75% of costs). Recognizes 75% of \$10 million (\$7.5 million) in total revenue. Since \$5 million was already recognized, an additional \$2.5 million is recognized in Year 2. **Key Concept**: Revenue is recognized gradually based on the percentage of costs incurred, reflecting the progress of the project.   **Example Acting as an agent** **Agent**: Reports only the commission as revenue (net amount). **Principal**: Reports the full sale price as revenue, but also records the cost of goods sold (gross amount). **Acting as Principal:** **Revenue**: \$10,000 (full ticket price) **Expense**: \$9,000 (ticket cost) **Gross Profit**: \$1,000 (\$10,000 - \$9,000) **Profit Margin**: 10% (\$1,000 / \$10,000) **Acting as Agent:** **Revenue**: \$1,000 (commission) **Expense**: \$0 (no ticket cost) **Gross Profit**: \$1,000 **Profit Margin**: 100% (\$1,000 / \$1,000)       **Franchising and Licensing Explained:** Imagine a fast food company that both owns and operates restaurants and also allows other people (franchisees) to run restaurants using its brand name and guidelines. The company earns money from two main things: **Franchise Fees**: Franchisees pay a one-time fee to operate using the company\'s brand. **Royalties**: The company gets a percentage (e.g., 2%) of the franchisee\'s sales (turnover). **Revenue Categories:** The fast food company must break its total revenue into separate categories because these categories have different characteristics (such as when the revenue is received or how risky it is): **Revenue from Company-Owned Restaurants**: This is the money the company makes directly from its own restaurants. **Franchise Royalties and Fees**: Money earned from franchisees, including the one-time franchise fee and ongoing royalty payments based on sales. **Revenue from Supplies to Franchises**: Revenue from selling products (like equipment, food ingredients) to the franchisees. **Franchise Fees Treatment:** The **franchise fee** is typically paid upfront but is for the right to operate over many years. So, it is first treated as **deferred revenue** (i.e., money received but not yet earned). Over time, as the franchisee continues operating the restaurant, the franchise fee is **amortized** (spread out) into revenue. This means it's recognized gradually as income over the contract period, not all at once. **Royalty Fees Treatment:** **Royalties** are earned periodically (e.g., every month or quarter) as the franchisee makes sales. The company recognizes royalty revenue when it becomes due and payable, according to the contract. **Key Points for Notes:** **Franchise fees** are initially recorded as **deferred revenue** and then gradually recognized over time. **Royalties** are recognized when they are due based on the franchisee\'s sales. **Revenue is categorized** based on similar characteristics: company-owned restaurant revenue, franchise revenue, and supplies revenue. **Deferred revenue** is money that a company has received in advance for goods or services that it has not yet delivered or performed. Essentially, it\'s a liability on the company\'s balance sheet because the company still owes the customer the product or service in the future.   **Service versus license** **1. License to Install Software (Purchased License)** When customers purchase a **license** to install software on their own systems, the software supplier has two options for recognizing revenue depending on the nature of the agreement: **a) Revenue Recognized Over the Life of the Contract** **When**: If the supplier will continue to update and improve the software during the contract. **Why**: The customer gets ongoing benefits from updates and enhancements, even though these updates do not directly result in a transfer of a new product or service. **How**: Revenue is recognized gradually over time, as the supplier provides these updates and enhancements. **b) Revenue Recognized Upfront (At the Start)** **When**: If the license grants the customer the right to use the software as it is at the beginning of the contract (no ongoing updates required). **Why**: The software is considered \"sold as is,\" and the customer gains the right to use it immediately. There is a **separate contract** for updates or enhancements. **How**: Revenue for the license is recognized upfront, while revenue for **support services** is recognized over time (as the services are provided). **2. Cloud-Based Software (Access via Internet)** **What Happens**: If customers access the software via the cloud (without taking physical possession), the contract is treated as a **service**, not a license. **How**: Revenue is recognized over the life of the contract as the customer uses the service. There is no immediate transfer of ownership, and the supplier provides ongoing access, updates, and services. **In Summary:** **For a license with updates**: Revenue can be recognized over time (if updates/enhancements are part of the contract). **For a license with no updates**: Revenue is recognized upfront. **For cloud access**: Revenue is recognized over time, as it is a service rather than a one-time license.     A **bill-and-hold agreement** is a sales arrangement where the **customer pays for goods** before they are shipped. Usually, in such cases, **revenue** is recognized later (when the goods are shipped). However, **revenue** can be recognized **before shipping** if certain conditions are met, showing that the supplier has fulfilled its obligations and the customer has control over the goods. **IFRS Criteria for Recognizing Revenue Early:(CARGO easy to remember**) **Customer Request**: The customer must ask for the bill-and-hold arrangement. **Goods Identified**: The goods must be clearly identified as belonging to the customer. **Goods are Ready**: The goods must be complete and ready for delivery to the customer. **Goods Cannot be Redirected**: The goods should not be able to be sold or sent to another customer. **Summary:** Revenue can be recognized before shipping in a **bill-and-hold agreement** if the supplier meets the above conditions, showing that the customer has control over the goods, even though they haven\'t received them yet.   **Required Disclosures under Converged Standards:** **Contracts with Customers by Category**: Disclose revenue from contracts categorized by type or nature. **Assets and Liabilities Related to Contracts**: Report balances and changes in assets and liabilities linked to contracts. **Outstanding Performance Obligations**: List remaining performance obligations and the transaction prices assigned to them. **Management Judgments**: Disclose judgments used in determining when and how revenue is recognized, including any changes to those judgments. **Summary:** These disclosures help provide transparency on how revenue is recognized, any judgments made by management, and the status of contracts and obligations.     **MODULE 28.2: EXPENSE RECOGNITION 1/13/2025** LOS **General Principles of Expense Recognition** **Specific Expense Recognition Applications** **Implications of Expense Recognition Choices for Financial Analysis** **Capitalized Costs vs. Expensed Costs**   **Net Income**: Calculated as **Revenue** minus **Expenses**. **IASB Definition of Expenses**: **Decreases in economic benefits** during the period due to **outflows**, **asset depletion**, or **liability incurrence** that reduce **equity** (excluding distributions to equity participants). +-----------------------------------------------------------------------+ | **Liability Incurrence** means the company has a debt or obligation, | | which will reduce its resources (money) when it's settled. | | | | **Breaking it Down:** | | | | 1. **Decreases in Economic Benefits** | | | | - **Expenses reduce the overall value or resources (economic | | benefits) a company has available.** | | | | 2. **Outflows** | | | | - **Money spent or resources used, like paying salaries or | | utility bills.** | | | | 3. **Asset Depletion** | | | | - **The reduction in the value of company assets, such as | | inventory sold or the wear and tear on equipment | | (depreciation).** | | | | 4. **Liability Incurrence** | | | | - **When the company owes money, like taking on debt or | | accruing expenses it hasn't paid yet (e.g., unpaid rent).** | | | | 5. **Reduce Equity** | | | | - **Expenses lower the owner's stake (equity) in the business | | because they decrease net income, which is part of equity.** | | | | 6. **Excluding Distributions to Equity Participants** | | | | - **This doesn't include payments made to shareholders, like | | dividends, because those are not considered | | expenses---they're a distribution of profits** | +-----------------------------------------------------------------------+ **Cash Basis Accounting**: Simplifies financial statements by recognizing **cash received** as **revenue** and **cash paid** as **expense**, avoiding the need for revenue or expense recognition principles. **Expense Recognition Under Accrual Accounting** Expenses are recognized in the **period when economic benefits are consumed**, not when cash is paid. **Methods of Expense Recognition:** **Matching Principle**: Match expenses to the revenue they help generate (e.g., cost of goods sold). +-----------------------------------------------------------------------+ | **Matching Principle Example:** | | | | The **Matching Principle** means you record expenses in the same | | period as the revenue they help generate. This ensures the financial | | statements show an accurate relationship between costs and income. | | | | **Simple Example:** | | | | 1. A company sells 1,000 units of a product in January for \$10 | | each. | | | | - **Revenue** for January = 1,000 × \$10 = **\$10,000**. | | | | 2. The company paid \$5 per unit to manufacture those products. | | | | - **Cost of Goods Sold (COGS)** for January = 1,000 × \$5 = | | **\$5,000**. | | | | 3. In January, the company recognizes: | | | | - **\$10,000 as revenue** (from sales). | | | | - **\$5,000 as COGS** (the expense to produce the goods sold). | +-----------------------------------------------------------------------+ **Expensing as Incurred**: Record expenses immediately when they occur (e.g., office supplies, utilities). +-----------------------------------------------------------------------+ | **Key Idea:** | | | | Expenses that don't directly create future benefits (like office | | supplies or utility bills) are recorded **immediately** when they | | occur, without being matched to revenue. | | | | **Simple Example:** | | | | 1. A company pays **\$500 for office supplies** (like paper, pens, | | etc.) in January. | | | | - These supplies are not directly linked to any specific sale | | or revenue. | | | | 2. In January, the company immediately records: | | | | - **\$500 as an expense** on the income statement. | +-----------------------------------------------------------------------+ **Capitalization**: Treat expenditures as an asset and spread the expense over time as the asset is used (e.g., equipment depreciation). +-----------------------------------------------------------------------+ | **What Capitalization Means:** | | | | When a company **capitalizes** an expense, it doesn't treat it as a | | cost right away. Instead, the expense is recorded as an **asset** on | | the balance sheet because it provides value for a longer period. Over | | time, the cost of the asset is gradually **spread out** (expensed) | | across the periods when it's used. | | | | This process ensures that the expense matches the benefit it | | provides. | | | | **Simple Example:** | | | | 1. A company buys a machine for \$10,000. | | | | - Instead of recording the full \$10,000 as an expense | | immediately, it's recorded as an **asset** on the balance | | sheet. | | | | 2. The machine is expected to last for 5 years. | | | | - Each year, the company records **\$2,000 as depreciation | | expense** (\$10,000 ÷ 5 years). | +-----------------------------------------------------------------------+ **Matching Principle** **Definition**: Expenses are recognized in the **same period as the revenue** they help generate. **Examples**: **Inventory**: If inventory is purchased in Q4 and sold in Q1 of the next year: Recognize **revenue and cost of goods sold (COGS)** in Q1 when the inventory is sold, not when it's purchased. **Warranty Costs**: For goods sold with warranties, estimate and deduct the **warranty costs** at the time of sale, not when repairs or replacements occur. **Key Idea:** The matching principle ensures **expenses align with related revenue**, providing an accurate measure of profit for each period. **Capitalization** **Definition**: Capitalization applies the **matching principle** by recording costs as **assets** on the balance sheet. These costs are later expensed over time as their benefits are used, through **depreciation** (for tangible assets) or **amortization** (for intangible assets). **Period Costs** **Definition**: **Period costs** are expenses that **cannot be directly linked** to revenue generation and are **expensed immediately** in the period incurred. **Examples**: **Administrative Costs** **Rent**: If a company occupies leased premises, the rent for the year is expensed in that year, regardless of whether it\'s paid. **Expense Recognition: Aggressive vs. Conservative Policies -** **Aggressive Policy** **Definition**: Recognizes expenses **later**, which can inflate profits in the short term. **Example**: A company buys a machine for **\$10,000**. Instead of expensing it immediately, it records the cost as an asset on the balance sheet and spreads the cost over several years through **depreciation**. **Effect**: **Higher profits** in the short term, as the expense is delayed. **Key Idea**: **Aggressive** accounting policies **defer** expenses, making profits look larger initially. **Conservative Policy** **Definition**: Recognizes expenses **earlier**, which can reduce profits in the short term. **Example**: A company buys a machine for **\$10,000**. Under a conservative policy, the company records the full **\$10,000 as an expense** immediately. **Effect**: **Lower profits** in the current year, as the entire expense is recognized right away. **Key Idea**: **Conservative** accounting policies recognize expenses sooner, leading to **lower profits** in the short term. **Key Insight** **Expensing** immediately is considered **more conservative** than **capitalization**, as it reduces profits right away. **Capitalization** spreads the expense over time, making profits appear **higher in the short term**. **Conclusion** **Aggressive Policy**: Delays expense recognition, boosting short-term profits (e.g., capitalizing costs). **Conservative Policy**: Recognizes expenses right away, reducing short-term profits (e.g., expensing costs immediately +-----------------------------------------------------------------------+ | **Example 1 How the Matching Principle Works in This Case:** | | | | 1. **Sales and Cost of Goods Sold (COGS)**: | | | | - **The company sold 100 units. The cost of these 100 units is | | recognized as Cost of Goods Sold (COGS) in the income | | statement (I/S). These costs are directly matched to the | | sales revenue generated from selling these units.** | | | | 2. **Inventory Management**: | | | | - **The company had 110 units available for sale (20 from | | beginning inventory + 90 newly purchased).** | | | | - **After selling 100 units, only 10 units are left unsold, so | | the remaining 10 units are carried over to the balance sheet | | (B/S) as ending inventory.** | | | | 3. **Transfer to Balance Sheet**: | | | | - **The 10 unsold units become part of the company\'s ending | | inventory, and these are shown on the balance sheet as | | assets. These units will not be expensed until they are sold | | in the future.** | | | | 4. **What Remains in the Income Statement (I/S)**: | | | | - **The Cost of Goods Sold (COGS) reflects the 100 units sold, | | which is an expense in the income statement.** | | | | - **The remaining 10 units do not show up as an expense because | | they have not yet been sold. They are transferred to the | | balance sheet as inventory, which will be expensed in future | | periods when they are sold.** | +=======================================================================+ | **Example 2 Key Data and Transactions:** | | | | - **Beginning Inventory**: The company has 20 units at a total cost | | of **\$400**. | | | | - **Purchases**: The company bought inventory during the period: | | | | - Purchase 1: 20 units at **\$22 each** = **\$440** | | | | - Purchase 2: 30 units at **\$25 each** = **\$750** | | | | - Purchase 3: 30 units at **\$28 each** = **\$840** | | | | - Purchase 4: 10 units at **\$30 each** = **\$300\ | | Total Purchases** = **\$2,330**. | | | | - **Sales**: The company sold **100 units** at **\$35 each**, so | | total sales revenue is **\$3,500**. | | | | - **Ending Inventory**: The company has **10 unsold units** | | remaining, and it has identified which purchases these units came | | from: | | | | - **8 units** from **Purchase 4** (at \$30 each) | | | | - **2 units** from **Purchase 3** (at \$28 each)\ | | **Cost of Ending Inventory** = | | | | - 2 units from Purchase 3: 2 x \$28 = **\$56** | | | | - 8 units from Purchase 4: 8 x \$30 = **\$240\ | | Total Ending Inventory Cost** = **\$56 + \$240 = \$296**. | | | | **Key Calculation Breakdown:** | | | | 1. **Available for Sale**: The total inventory available for sale is | | the **beginning inventory** + **purchases**: | | | | - **Beginning Inventory: \$400** | | | | - **Purchases: \$2,330** | | | | - **Total Available for Sale = \$400 + \$2,330 = \$2,730** | | | | 2. **Cost of Goods Sold (COGS)**: | | | | - **The cost of goods sold (COGS) is the total cost of the 100 | | units sold during the period.\ | | Since we know the ending inventory (10 units) cost \$296, we | | can subtract the ending inventory from the total available | | for sale to calculate the COGS:** | | | | - **Available for Sale = \$2,730** | | | | - **Ending Inventory = \$296** | | | | - **COGS = \$2,730 - \$296 = \$2,434** | | | | 3. **Gross Profit**: The **gross profit** is the difference between | | the **revenue from sales** and the **cost of goods sold (COGS)**. | | | | - **Revenue from sales = \$3,500** | | | | - **COGS = \$2,434** | | | | - **Gross Profit = \$3,500 - \$2,434 = \$1,066** | | | | **How It All Ties Together:** | | | | - **Revenue**: The company sold **100 units** for **\$3,500**. | | | | - **Cost of Goods Sold (COGS)**: To match the sales with the | | appropriate costs, the company calculates that **\$2,434** is the | | cost of the 100 units sold. | | | | - **Ending Inventory**: The 10 unsold units are valued at | | **\$296**. This amount is transferred to the **balance sheet** as | | the ending inventory. | | | | - **Gross Profit**: After subtracting the COGS from the revenue, | | the company has a **gross profit of \$1,066**. | | | | **COGS=Beginning Inventory + | | Purchases during the period−Ending Inventory** | | | | **This example used the specific identification method to compute the | | cost of ending inventory** | | | |   | | | | The **specific identification method** tracks the exact items sold | | and remaining in inventory, **while FIFO, LIFO, and weighted average | | cost are used when specific identification is not possible**, | | assigning costs based on inventory flow assumptions. | +-----------------------------------------------------------------------+   **Capitalization vs. Expensing** When a firm incurs a **cost**, it can either **capitalize** it as an asset (if it provides future economic benefit over multiple periods) or **expense** it immediately (if the benefit is uncertain or unlikely). **Capitalizing**: The cost is recorded as an **asset** on the **balance sheet** and spread out as **depreciation**, **depletion**, or **amortization** over the asset\'s **useful life**. This reduces both the asset\'s value and **net income**. For example, machinery purchased is not expensed immediately; its cost is gradually allocated as depreciation over several years. **Expensing**: If the expenditure is not expected to provide future benefit, it is immediately expensed, directly reducing **pretax income** for the current period. **Routine Maintenance**: Costs that merely maintain the asset (e.g., repairs) are **expensed** when incurred. **Enhancements**: Expenditures that increase an asset\'s value or extend its life (e.g., upgrades) are **capitalized** and depreciated over time. **Key Points**: **Depreciation**: For **tangible assets**, reduces their value over time. **Depletion**: For **natural resources**, allocates the cost over the resource\'s life. **Amortization**: For **intangible assets** with finite lives, spreads the cost over time. Excluding **land** and **intangible assets with indefinite lives** (like **goodwill**), all capitalized costs are allocated through depreciation, depletion, or amortization. +-----------------------------------------------------------------------+ | **Capitalizing vs. Expensing: Example** | | | | - **Capitalizing**: Costs that provide **future economic benefits** | | or are necessary to get an asset ready for use are recorded as | | assets and spread out over time. | | | | - **Capitalized Costs**: | | | | - **Purchase price, freight, and taxes**: These are part of | | getting the asset ready for use, so they are capitalized. | | | | - **Installation costs**: Necessary to make the asset | | operational, thus capitalized. | | | | - **Rebuilding motors**: Extends the asset\'s life and | | enhances its future value, so it is capitalized. | | | | - **Reason for Capitalizing**: These costs increase the value | | of the asset and provide benefits over multiple periods, | | justifying their inclusion on the balance sheet and | | allocation over time. | | | | - **Expensing**: Costs that don't provide **future economic | | benefits** or are for **routine operations** are recognized | | immediately in the income statement as expenses. | | | | - **Expensed Costs**: | | | | - **Initial training costs**: The training prepares | | employees but doesn't directly enhance the asset, so | | it\'s expensed. | | | | - **Repairs and maintenance**: These costs don't extend the | | life or increase the value of the asset; they only | | maintain its current condition, so they are expensed. | | | | - **Reason for Expensing**: These costs don't provide long-term | | value or benefits; they only affect the current period's | | operations, so they are recognized as expenses immediately. | | | | **Key Reasoning**: | | | | - **Capitalized costs** add value or extend an asset's useful life, | | affecting the balance sheet and being spread out over time (via | | depreciation, amortization, or depletion). | | | | - **Expensed costs** are related to current-period operations or | | don't improve the asset, so they reduce current-period income | | immediate | +=======================================================================+ | **Example of how capitalizing vs. expensing the equipment affects the | | financial statements:** | | | | **Capitalization** spreads the **expense** of the equipment over its | | **useful life** in the income statement, leading to a more **stable** | | net income over time. | | | | **Expensing** recognizes the full **cost** of the equipment in the | | **first year**, reducing net income immediately. In subsequent years, | | there is no impact on earnings, causing **higher net income** in | | later years. | | | | **Key Points:** | | | | - **Capitalization** = Expense spread over asset\'s life → **Stable | | net income**. | | | | - **Expensing** = Full cost in first year → **Lower net income** in | | year 1, **higher net income** in future years. | | | | - **Capitalization** causes **less volatility** in earnings | | compared to **expensing**. | | | |   | +-----------------------------------------------------------------------+ [BASICS OF FINANCIAL ACCOUNTING](onenote:BASICS%20OF%20FINANCIAL%20ACCOUNTING.one#section-id=%7BBC1CCAC3-5C20-401B-AF6A-7B780ADD1ED3%7D&end&base-path=https://d.docs.live.net/8065979d48677a84/Documents/OneNote%20Notebooks/Financial%20statement%20analysis)   **EXAMPLE** the impact of **capitalizing** versus **expensing** the equipment on the **balance sheet** using your example. This focuses on **total assets** and **equity**. +-----------------------------------------------------------------------+ | **Impact of Capitalization vs. Expensing on Assets and Equity** | | | | - **Capitalization**: In the early years, **total assets** and | | **equity** are higher as the asset is included in the balance | | sheet, with its value decreasing over time due to depreciation. | | **Net income** and **retained earnings** are higher in Year 1 | | under capitalization. | | | | - **Expensing**: In the first year, **net income** is lower due to | | the full cost being recognized, but in subsequent years, it is | | higher as there are no depreciation charges. Over time, the | | differences between capitalization and expensing narrow, leading | | to identical values at the end of the asset's life. | | | | Factors of Convergence: | | | | 1. **Depreciation**: Reduces the carrying value of the asset under | | capitalization. | | | | 2. **Net Income Adjustment**: Lower in Year 1 for expensing but | | higher in subsequent years. | +-----------------------------------------------------------------------+ **Capitalizing versus expensing equipment cost, and how each affects the cash flow statement.** [BASICS](onenote:BASICS%20OF%20FINANCIAL%20ACCOUNTING.one#BASICS&section-id=%7BBC1CCAC3-5C20-401B-AF6A-7B780ADD1ED3%7D&page-id=%7BCC8628FF-9D28-4C2B-9065-C57DC0D586E3%7D&end&base-path=https://d.docs.live.net/8065979d48677a84/Documents/OneNote%20Notebooks/Financial%20statement%20analysis) **Impact of Capitalization vs. Expensing on Cash Flow** **Capitalization**: The equipment investment is treated as a **cash outflow** from **investing activities**. The **tax benefit** is spread out over the life of the asset through depreciation. **Expensing**: The full cost of the equipment is treated as a **cash outflow** from **operating activities**. The **tax benefit** is fully recognized in **Year 1**. **Key Difference**: **Capitalization**: Spreads tax benefit over time. **Expensing**: Full tax benefit in Year 1. **Convergence**: At the end of the asset\'s life, total **cash flow** is identical under both approaches.   +-----------------------------------+-----------------------------------+ | **capitalization** versus |   | | **expensing** costs and how they | | | affect financial ratios over | | | time. | | | | | | **1. Total Asset Turnover** | | | | | | This ratio measures how | | | efficiently a company is using | | | its assets to generate sales. It | | | is calculated as: | | | | | | Total Asset Turnover= | | | | | |   | | | | | | A math equation with black text | | | Description automatically | | | generated | | | | | | **What's Happening with | | | Capitalization vs. Expensing:** | | | | | | - **Capitalization** means that | | | instead of treating the cost | | | of an asset (like equipment) | | | as an immediate expense, it's | | | recorded as an asset on the | | | balance sheet and depreciated | | | over time. | | | | | | - **Expensing** means the | | | entire cost of the asset is | | | recognized as an expense | | | immediately in the income | | | statement. | | | | | | In the case of | | | **capitalization**, since the | | | asset is added to the balance | | | sheet (and depreciated | | | gradually), the total asset base | | | is **higher** in the first year. | | | This higher asset base means that | | | sales will be spread across a | | | larger amount of assets, which | | | **lowers the total asset | | | turnover** ratio. | | | | | | - **In Year 1**, with | | | **capitalization**, the ratio | | | is 0.7, but with | | | **expensing**, the ratio is | | | higher at 0.8 because the | | | asset value is not on the | | | balance sheet. | | | | | | - Over time, as the **asset | | | depreciates**, the difference | | | between the two approaches | | | narrows, and in later years, | | | the **asset turnover** ratio | | | becomes the same (0.5 in both | | | cases). | | | | | | **Conclusion:** | | | | | | - **Capitalization** leads to a | | | **lower** total asset | | | turnover initially because of | | | higher assets on the balance | | | sheet. | | | | | | - **Expensing** gives a | | | **higher** turnover in the | | | beginning because the asset | | | cost is not capitalized on | | | the balance sheet. | | | | | |   | | | | | | **2. Net Profit Margin** | | | | | | This ratio shows how much profit | | | a company makes for every dollar | | | of sales. It is calculated as: | | | | | | Net Profit Margin= | | | | | |   | | | | | |  | | | | | | **What's Happening with | | | Capitalization vs. Expensing:** | | | | | | - In **Year 1**, if you | | | capitalize the cost, you | | | spread the asset\'s expense | | | (depreciation) over several | | | years. The full £12,000 cost | | | isn\'t recognized immediately | | | in Year 1. Instead, only | | | £3,000 of depreciation is | | | recognized, which **boosts** | | | net income and **raises the | | | net profit margin** for that | | | year. | | | | | | - If you **expense** the full | | | £12,000 cost in Year 1, net | | | income will be significantly | | | lower, and the **net profit | | | margin** will be **lower** as | | | well. | | | | | | - **In Year 1**, | | | **capitalization** gives a | | | higher net profit margin | | | (21%), as depreciation is | | | lower in Year 1. | | | | | | - **From Year 2 onward**, | | | **expensing** provides a | | | higher net profit margin | | | (28%) because, under | | | **capitalization**, the | | | company continues to record | | | depreciation in the income | | | statement (which reduces net | | | income), whereas there is no | | | cost in the income statement | | | after Year 1 if the cost is | | | expensed. | | | | | | **Conclusion:** | | | | | | - **Capitalization** leads to | | | **higher net profit margin** | | | in the first year because | | | depreciation is lower. | | | | | | - **Expensing** leads to | | | **higher net profit margins** | | | in subsequent years since no | | | further depreciation is | | | charged after the first year. | | | | | |   | | | | | | **3. Return on Equity (ROE)** | | | | | | This ratio measures the | | | profitability of a company in | | | relation to its equity (the | | | shareholders\' funds). It's | | | calculated as: | | | | | | ROE= | | | | | |   | | | | | | A close-up of a logo Description | | | automatically generated | | | | | | ​ | | | | | | **What's Happening with | | | Capitalization vs. Expensing:** | | | | | | - In **Year 1**, if the cost is | | | **capitalized**, the company | | | has lower depreciation | | | expense, which means **higher | | | net income** and thus | | | **higher ROE** in Year 1. | | | | | | - In subsequent years, | | | **capitalization** continues | | | to charge depreciation, | | | reducing net income over | | | time, leading to **lower | | | ROE** in the following years | | | compared to **expensing**. | | | | | | - **In Year 1**, | | | **capitalization** results in | | | a **higher ROE** (14%) due to | | | higher net income. | | | | | | - **From Year 2 onward**, | | | **expensing** leads to | | | **higher ROE** compared to | | | **capitalization** because | | | net income remains higher | | | under expensing (since | | | there's no ongoing | | | depreciation charge after the | | | first year). | | | | | | **Conclusion:** | | | | | | - **Capitalization** gives a | | | **higher ROE** in Year 1 but | | | **lower ROE** in later years | | | due to continued | | | depreciation. | | | | | | - **Expensing** results in | | | **lower ROE** in Year 1 but | | | **higher ROE** from Year 2 | | | onward because the entire | | | cost is recognized upfront. | | | | | |   | | | | | | **Summary of the Differences in | | | Ratios:** | | | | | | **Ratio** ** | | | Capitalization** | | | **Expensing** | | | ---------------------------- -- | | | --------------------------------- | | | ------------- ------------------- | | | -------------------------- | | | **Total Asset Turnover** Lo | | | wer in Year 1, narrows over time | | | Higher in Year 1, n | | | arrows over time | | | **Net Profit Margin** Hi | | | gher in Year 1, constant in subse | | | quent years Lower in Year 1, hi | | | gher in subsequent years | | | **Return on Equity (ROE)** Hi | | | gher in Year 1, lower in subseque | | | nt years Lower in Year 1, hi | | | gher in subsequent years | | | | | | **Key Takeaways:** | | | | | | 1. **Capitalization** results in | | | higher **net income and ROE** | | | initially but can cause lower | | | **asset turnover**. | | | | | | 2. **Expensing** reduces net | | | income initially but leads to | | | better profitability ratios | | | (like **net profit margin** | | | and **ROE**) in later years | | | because the full cost is | | | recognized upfront, with no | | | ongoing depreciation charges. | | | | | | 3. Both approaches **converge** | | | over time, meaning that by | | | the end of the asset's life, | | | both methods will result in | | | the same financial results. | | +===================================+===================================+ | key differences between |   | | **capitalizing** and | | | **expensing** costs and their | | | impact on a company\'s | | | **financial statements**. Let\'s | | | break it down step by step: | | | | | | **Key Terms:** | | | | | | - **Capitalization**: Treating | | | a cost as an asset and | | | spreading it over several | | | years. This means the expense | | | is recorded on the balance | | | sheet and then depreciated | | | over time. | | | | | | - **Expensing**: Recognizing | | | the full cost immediately as | | | an expense on the income | | | statement. The entire cost is | | | recorded in the period when | | | it is incurred. | | | | | | **Impact on Financial | | | Statements:** | | | | | | **Effect** | | | **Capitalizing** **Expen | | | sing** | | | ------------------------------- | | | ------ ------------------ ------- | | | -------- | | | **Assets & Equity** | | | **Higher** **Lower | | | ** | | | **Net Income (First Year)** | | | **Higher** **Lower | | | ** | | | **Net Income (Other Years)** | | | **Lower** **Highe | | | r** | | | **Income Variability** | | | **Lower** **Highe | | | r** | | | **ROA & ROE (First Year)** | | | **Higher** **Lower | | | ** | | | **ROA & ROE (Other Years)** | | | **Lower** **Highe | | | r** | | | **Debt Ratio & Debt-to-Equity** | | | **Lower** **Highe | | | r** | | | **CFO (Cash Flow from Operation | | | s)** **Higher** **Lower | | | ** | | | **CFI (Cash Flow from Investing | | | )** **Lower** **Highe | | | r** | | | | | | **Understanding the Effects:** | | | | | | 1. **Assets & Equity**: | | | | | | - **Capitalizing increases | | | assets and equity because | | | the cost is initially | | | recorded as an asset on | | | the balance sheet.** | | | | | | - **Expensing immediately | | | reduces equity because | | | the cost is recognized as | | | an expense.** | | | | | | 2. **Net Income**: | | | | | | - **Capitalizing leads to | | | higher net income in the | | | first year because only | | | depreciation (a small | | | portion of the cost) is | | | recognized, while the | | | full cost is spread over | | | multiple years.** | | | | | | - **Expensing results in | | | lower net income in the | | | first year because the | | | entire cost is recognized | | | immediately.** | | | | | | 3. **Net Income (Other Years)**: | | | | | | - **Capitalizing leads to | | | lower net income in | | | subsequent years because | | | depreciation continues to | | | be deducted from | | | income.** | | | | | | - **Expensing results in | | | higher net income in the | | | following years, as no | | | further costs are | | | recognized after the | | | first year.** | | | | | | 4. **Income Variability**: | | | | | | - **Capitalizing makes | | | income smoother because | | | the expense is spread out | | | over the asset\'s life, | | | reducing fluctuations.** | | | | | | - **Expensing causes more | | | variability in income, | | | with a significant drop | | | in the first year | | | followed by higher | | | earnings in later | | | years.** | | | | | | 5. **ROA & ROE (Return on Assets | | | & Return on Equity)**: | | | | | | - **Capitalizing boosts ROA | | | and ROE in the first year | | | because the company shows | | | higher net income and | | | assets.** | | | | | | - **Expensing lowers ROA | | | and ROE in the first | | | year, but improves in | | | subsequent years once the | | | full cost has been | | | recognized.** | | | | | | 6. **Debt Ratio & | | | Debt-to-Equity**: | | | | | | - **Capitalizing keeps the | | | debt ratio and | | | debt-to-equity ratio | | | lower because more equity | | | is on the balance sheet | | | due to the asset | | | capitalization.** | | | | | | - **Expensing increases the | | | debt ratio and | | | debt-to-equity ratio | | | because fewer assets are | | | capitalized, resulting in | | | lower equity.** | | | | | | 7. **CFO (Cash Flow from | | | Operations)**: | | | | | | - **Capitalizing results in | | | higher CFO in the first | | | year because the full | | | cost is not deducted as | | | an expense.** | | | | | | - **Expensing results in | | | lower CFO since the cost | | | reduces cash flow from | | | operations in the first | | | year.** | | | | | | 8. **CFI (Cash Flow from | | | Investing)**: | | | | | | - **Capitalizing results in | | | lower CFI because the | | | cost is capitalized as an | | | asset, rather than being | | | immediately expensed as | | | an outflow.** | | | | | | - **Expensing leads to | | | higher CFI because the | | | full cost is deducted | | | from cash flow from | | | operations, resulting in | | | a larger outflow in the | | | first year.** | | | | | | **Long-Term Impact of | | | Capitalization:** | | | | | | If a company continues to | | | capitalize costs in future | | | periods, the **profit-enhancing | | | effects** of capitalization will | | | continue. However, these effects | | | will depend on how much of the | | | new capitalized cost exceeds the | | | depreciation expense. Over time, | | | these effects decrease, but they | | | persist as long as capitalized | | | costs remain higher than | | | depreciation. | | | | | | **Conclusion:** | | | | | | - **Capitalization** initially | | | boosts profits, equity, and | | | cash flows but leads to lower | | | profits and cash flows in | | | later years due to | | | depreciation. | | | | | | - **Expensing** lowers profits | | | in the first year but | | | increases profitability and | | | cash flow in subsequent years | | | as the cost is recognized | | | upfront. | | | | | | When comparing companies, it is | | | essential to be aware of how each | | | company treats significant | | | expenditures (whether capitalized | | | or expensed), as it affects their | | | financial ratios, profitability, | | | and cash flows differently. | | | | | |   | | +-----------------------------------+-----------------------------------+ **Capitalized Interest** **Definition**: Capitalized interest refers to the interest that accrues during the construction of an asset for a company\'s own use (or resale in limited cases). This interest is added to the asset\'s cost rather than being expensed immediately. **Purpose**: The goal of capitalizing interest is to accurately reflect the total cost of constructing an asset and to match the cost with the revenues generated by the asset over time. **Accounting Treatment**: Under **U.S. GAAP** and **IFRS**, capitalized interest is not recognized as an interest expense in the income statement. Instead, it is included in the asset\'s cost and depreciated over the asset\'s useful life (for assets used) or reported as **COGS** (for assets held for resale). Capitalized interest is recorded in the **cash flow statement** as an outflow from **investing activities**, unlike typical interest expense, which is an outflow from **operating activities** under U.S. GAAP and may be reported as either operating or financing outflows under IFRS. **Analyst Considerations**: Analysts should account for both capitalized and expensed interest when calculating **interest coverage ratios** to get a clearer view of a company\'s **solvency**. Any depreciation related to capitalized interest should be **added back** when adjusting net income to assess the impact on profitability. **Key Takeaways:** Capitalizing interest helps match costs with future revenues but impacts financial statements differently than expensing it. Adjust financial ratios by including capitalized interest for more accurate solvency and profitability analysis **Capitalization of Interest: CFA Explanation** **1. Capitalization of Interest -- Concept** **Capitalized Interest**: When a company constructs an asset, any interest incurred during the construction phase is added to the cost of the asset (capitalized) instead of being expensed immediately. This aligns with the matching principle in accounting, which ensures that the cost is recognized when the asset generates revenue. **2. Example Overview (Willock AG)** **Company**: Willock AG, a German infrastructure company, constructs equipment for its own use in large projects. **Reported EBIT**: €160 million **Reported Interest Expense**: €80 million **Capitalized Interest**: €20 million (capitalized into the cost of construction in the current period) **Depreciation from Prior Capitalized Interest**: €10 million **3. Adjusting the Interest Coverage Ratio for Capitalized Interest** Interest coverage ratio shows a company\'s ability to pay interest on its debt with its operating income (EBIT). **Interest Coverage Ratio (Before Adjustment)**: Formula:        A math problems with numbers and equations Description automatically generated with medium confidence     **Cash Flow Impact of Capitalized Interest** **Cash Flow from Operations (CFO)**: The cash flow directly related to the company's operational activities. **Cash Flow from Investing (CFI)**: Cash flow related to investments in assets, including purchases or sales of fixed assets. **Capitalized Interest Impact on CFO and CFI**: Capitalized interest is recorded in the **CFI** (Investing activities) and **does not appear in CFO** (Operating activities) directly. This is because capitalized interest is treated as part of the cost of an asset rather than an expense. **Without Capitalizing Interest**: If the interest had been expensed, it would have reduced CFO and increased CFI. **Example (Continued)**: **Reported CFO**: €70 million **Reported CFI**: -€50 million Capitalized interest was €20 million, meaning the interest was added to the asset and not expensed. **Impact of Capitalization on CFO and CFI**: **CFO (Cash Flow from Operations)**: Had the interest been expensed, it would have reduced CFO by €20 million (since expensed interest is part of operating expenses). New CFO=70million−20million=50million **CFI (Cash Flow from Investing)**: Capitalizing interest means it's not deducted from CFI. If the interest had been expensed, it would have decreased the CFI (since expensed interest would have been reported as an outflow under operating activities instead). New CFI=−50million+20million=−30million **Key Takeaways for Your CFA Exam:** **Capitalizing Interest**: Capitalized interest increases **asset values** and **equity** (on the balance sheet). It reduces **interest expense** in the **income statement** during the construction period but adds to **depreciation** once the asset is in use. **Adjusted Interest Coverage** is lower after adjusting for capitalized interest because the capitalized interest increases both EBIT and interest expense. Capitalized interest affects the **cash flow statement**: CFO is **lower** (because interest capitalized does not count as an operating outflow). CFI is **lower** (because capitalized interest is treated as part of the investment in the asset). **Interest Coverage Ratio**: The **interest coverage ratio** is a key indicator of a company\'s ability to meet interest payments. Adjusting for capitalized interest can show a more accurate picture of solvency, especially when comparing companies that may use different approaches to handle construction interest. **Adjustments for Analysts**: Always adjust financial ratios like **interest coverage** when capitalized interest is involved. Remember that **capitalized interest** has a non-cash impact (depreciation), and that should be factored in when analyzing cash flow statements or adjusting EBIT. By understanding these concepts, you\'ll be able to assess how companies handle large capital projects and accurately interpret financial ratios and cash flows for your CFA exam. **Research and Development Costs** **IFRS vs. U.S. GAAP**: **IFRS**: **Research Costs**: Expensed as incurred (focused on discovering new scientific or technical knowledge). **Development Costs**: Can be **capitalized** if certain criteria are met (e.g., ability to complete and sell the asset). **U.S. GAAP**: Both **Research and Development Costs** are generally expensed as incurred. **Software Development Costs**: Expensed until technological feasibility is established, then capitalized. **Adjustments for Comparability**: When comparing companies with different treatments for development costs: **Income Statement**: Adjust to include all development costs as expenses and remove any amortization of capitalized development costs. **Balance Sheet**: Remove capitalized development costs, leading to lower assets and equity. **Cash Flow Statement**: Adjust by removing capitalized costs from CFI and adding them to CFO, which decreases CFO. **Bad Debt and Warranty Expense Recognition**: **Bad Debt and Warranty Expenses**: Recognized when the sale is made, based on estimates. Analysts should scrutinize changes in expense estimates, as aggressive recognition (delaying expense recognition) may artificially inflate net income. Comparisons should be made to industry peers to understand if differences in estimates are due to genuine performance or aggressive accounting. **Implications for Financial Analysis**: Analysts need to understand the reasoning behind changes in estimates (e.g., bad debt or warranty expenses) to assess whether they reflect operational improvements or accounting manipulations. Disclosures in financial statements provide critical insight into a firm\'s accounting policies and estimates   **MODULE 28.3: NONRECURRING ITEMS** **Unusual or Infrequent Items: Key Points** **Definition**: Events that are **unusual in nature**, **infrequent in occurrence**, and **material** enough to impact financial statement users. **Examples**: **Gains or losses** from the sale of assets or part of a business (non-operational activities). **Impairments**, **write-offs**, and **write-downs**. **Restructuring costs**. **Reporting**: Included in **income from continuing operations**. Reported **before tax**. **Analyst Focus**: **Review carefully** to decide if these items should be excluded when **forecasting earnings**. Companies with frequent "**unusual or infrequent**" losses may indicate recurring issues(**regular issues**.)   **Discontinued Operation**: An operation that management has decided to dispose of but has not yet done so, or has disposed of in the current year after generating income or losses. **Criteria**: Must be **physically and operationally distinct** from the rest of the firm (assets, operations, investing, and financing activities). **Measurement Date**: The date the company develops a **formal disposal plan**. **Phaseout Period**: Time between the **measurement date** and the actual disposal date. **Reporting**: Income or loss from discontinued operations is reported **separately** in the income statement, **net of tax(**after tax,), after **income from continuing operations**. Past income statements must be **restated**, separating discontinued operations\' income or loss. **Accruals**: Estimated **losses** during the phaseout period and any **estimated loss on sale** are accrued on the measurement date. **Gains** on disposal cannot be reported until after the sale is completed. **Analysis**: Discontinued operations do not affect **net income** from continuing operations and should be **excluded** when forecasting future earnings. However, the event of discontinuing a segment may provide insights into the firm's **future cash flows**.     **Changes in Accounting Policies and Estimate** **Changes in Accounting Policies, Estimates, and Prior-Period Adjustments:** **Changes in Accounting Policies** **What it is**: A company changes the rules it follows for accounting. For example, the company may decide to use a different method for calculating the cost of inventory (e.g., moving from First-In-First-Out (FIFO) to Last-In-First-Out (LIFO)). **Example**: A company that previously counted its inventory costs using FIFO (old policy) switches to using LIFO (new policy). **Application**: **Retrospective**: The company would need to **go back** and adjust its previous financial statements to reflect this new method as if it had been using LIFO all along. This makes the financial reports more **comparable** over time. **Changes in Accounting Estimates** **What it is**: This happens when a company updates its judgment or estimates about something. These estimates are based on information available at the time, and they can change as new data comes in. For example, how long the company expects an asset to last (its useful life). **Example**: A company owns a machine and originally thought it would last 5 years, but now, after further analysis, it believes the machine will last 8 years. This change in **useful life** is a change in accounting estimate. **Application**: **Prospective**: The company does **not need to change past financial statements**. The new estimate will apply **only going forward**. The financial statements will reflect the new useful life of the machine from the current year onward. **Prior-Period Adjustments** **What it is**: Sometimes, a company realizes it made a mistake in the past (like miscalculating something), or it has to change an accounting method to comply with new rules. This correction is called a **prior-period adjustment**. **Example**: A company mistakenly reported its revenue too high in previous years, but now it realizes it made an error. It needs to **correct** those past financial statements to show the correct revenue. **Application**: **Retrospective**: The company will **go back** and fix its previous financial statements (they'll be "restated") to show the **corrected numbers** as if the mistake never happened.   **1. Changes in Accounting Policies** **Application Retrospective**: **2. Changes in Accounting Estimates** **Application Prospective**: **3. Prior-Period Adjustments** **Application Retrospective**:       **Changes in Accounting Policies** **Standard-setting bodies** sometimes **issue changes** in accounting policies. A **firm** may also **change its policy** voluntarily, such as: **Changing inventory costing methods** (e.g., FIFO to LIFO). **Capitalizing vs. expensing** specific purchases. **Retrospective application** is required unless it is impractical. This involves **adjusting prior-period financial statements** to reflect the new policy. The goal is to ensure **comparability** of financial statements over time **Modified Retrospective Application** **Modified retrospective application** allows firms to adopt **new revenue recognition standards** without **restating prior-period statements**. Instead, firms adjust the **beginning values of affected accounts** for the **cumulative effects** of the change. **Changes in Accounting Estimates** A **change in accounting estimate** occurs when **management updates its judgment** due to **new information**. Example: Revising the **useful life of an asset** based on updated analysis. **Applied prospectively**: No need to **restate prior financial statements**; the change affects only **future statements**. Typically, **does not impact cash flow**, but analysts should evaluate the effect on **future operating results**. **Prior-Period Adjustments** A **prior-period adjustment** corrects **errors** or adopts an **acceptable accounting method** under GAAP or IFRS. **Retrospective application**: Requires **restatement of prior financial statements**. Disclosure of the **nature** of the adjustment and its **effect on net income** is mandatory. Typically, **no cash flow impact**, but analysts should assess for potential **internal control weaknesses**.   **Changes in Scope and Exchange Rates** **Disclosure Requirement**: Accounting standards **do not require firms** to disclose the impact of changes in scope or exchange rates on financial statements. **Changes in Scope**: Refers to how **mergers or acquisitions** affect the **size of the combined entity**. These changes can significantly **reduce comparability** of financial statements **before and after the acquisition date**. **Exchange Rate Fluctuations**: Impact firms engaged in **overseas trade** or owning **foreign subsidiaries**. Overseas **sales and purchases** and **subsidiary income statements** must be **converted to the reporting currency**, potentially affecting reported results. **Analyst\'s Role**: Analysts must remain **alert to these effects**, even without mandatory disclosures, to evaluate financial performance accurately. **MODULE 28.4: EARNINGS PER SHARE**   **Earnings Per Share (EPS)** **Definition**: A key profitability measure for publicly traded companies. **Only for Common Stock**: EPS is reported for common (ordinary) stock. **Not Required for Private Companies**: Non-public companies are not required to report EPS. **Purpose**: Used to assess corporate profitability. **Capital Structure Types** **Simple Capital Structure** **Definition**: No potentially dilutive securities. **Components**: Common stock Nonconvertible debt Nonconvertible preferred stock **Characteristics**: No securities that could dilute existing shares. **Complex Capital Structure** **Definition**: Contains potentially dilutiv