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Accounting for Managers - Ch. 10 PP
Terms in this set (40)
more than a set of structures, control mechanisms, rules, and regulations that directors, officers, and employees must follow.
- At the core of the governance concept are issues of:
---> business ethics
---> social responsibility
---> equitable treatment of stakeholders
---> full and fair disclosure
---> the responsibilities of the board of directors and its various committees.
- The most powerful legislation to date has been the Sarbanes-Oxley Act (SOX) of 2002.
- In response to the financial crisis of 2007-2008, Congress passed the Wall Street Reform and Consumer Protection Act of 2010 (referred to as the Dodd-Frank Act).
Sarbanes-Oxley Act (SOX) of 2002
created the Public Company Accounting Oversight Board (PCAOB) as the authoritative watchdog over the accounting and auditing profession.
- The SOX legislation was aimed primarily to curtail the misbehavior of senior management of corporate entities: Chief executive officers (CEOs) and chief financial officers (CFOs) are required under SOX to attest (in front of a notary) to the correctness of their company's financial statements.
- The companies registered under the SEC must also report in a separate section of its annual 10-K report any "Changes in and Disagreements with Accountants on Accounting and Financial Disclosure" as an added measure of transparency and management accountability.
Dodd-Frank Act (Wall Street Reform and Consumer Protection Act) of 2010
Passed by Congress in response to the financial crisis of 2007-2008.
- Although most of the act deals with financial regulation, several Dodd-Frank provisions impose new corporate governance rules not just on Wall Street banks but also on Main Street public corporations.
- The Dodd-Frank Act contains the "say on pay" mandate requiring periodic shareholder advisory votes on executive compensation and golden parachute provisions.
- Another Dodd-Frank provision requires companies to disclose the reasons that they have chosen to have either the same person or separate people serve as the CEO and board chair.
Earnings Manipulation Shenanigans (Recent Financial Misstatements)
1. Recording revenue too soon.
---> Recording revenue before completing any obligations under the contract.
---> Recording revenue far in excess of work completed on the contract.
---> Recording revenue before the buyer's final acceptance of the product.
---> Recording revenue when the buyer's payment remains uncertain or unnecessary.
2. Recording bogus revenue.
---> Recording revenue from transactions that lack economic substance.
---> Recording revenue from transactions that lack a reasonable arm's-length process.
---> Recording revenue on receipts from non-revenue-producing transactions.
---> Recording revenue from appropriate transactions, but at inflated amounts.
3. Boosting income using one-time or unsustainable activities.
---> Boosting income using one-time events.
---> Boosting income through misleading classifications.
4. Shifting current expenses to a later period.
---> Improperly capitalizing normal operating expenses.
---> Amortizing costs too slowly.
---> Failing to write down assets with impaired value.
---> Failing to record expenses for uncollectible receivables and devalued investments.
5. Employing other techniques to hide expenses or losses.
---> Failing to record an expense from a current transaction.
---> Failing to record an expense for a necessary accrual or reversing a past expense.
---> Failing to record or reducing expenses by using aggressive accounting assumptions.
---> Reducing expenses by releasing bogus reserves from previous charges.
6. Shifting current income to a later period.
---> Creating reserves (often in conjunction with an acquisition) and releasing them into income in a later period.
---> Improperly accounting for derivatives in order to smooth income.
---> Recording current-period sales in a later period.
7. Shifting future expenses to an earlier period.
---> Improperly writing off assets in the current period to avoid expenses in a future period.
---> Improperly recording charges to establish reserves used to reduce future expenses.
Cash Flow Shenanigans (Recent Financial Misstatements)
1. Shifting financing cash inflows to the operating section.
---> Recording bogus cash flows from operations from a normal bank borrowing.
---> Boosting cash flows from operations by selling receivables before the collection date.
---> Inflating cash flows from operations by faking the sale of receivables.
2. Shifting normal operating cash outflows to the investing section.
---> Inflating cash flows from operations with boomerang transactions.
---> Improperly capitalizing normal operating costs.
---> Recording the purchase of inventory as an investing outflow.
3. Inflating operating cash flow using acquisitions or disposals.
---> Inheriting operating inflows in a normal business acquisition.
---> Acquiring contracts or customers rather than developing them internally.
---> Boosting cash flows from operations by creatively structuring the sale of a business.
4. Boosting operating cash flow using unsustainable activities.
---> Boosting cash flows from operations by paying vendors more slowly.
---> Boosting cash flows from operations by collecting from customers more quickly.
---> Boosting cash flows from operations by purchasing less inventory.
---> Boosting cash flows from operations with one-time benefits.
Key Metrics Shenanigans (Recent Financial Misstatements)
1. Showcasing misleading metrics that overstate performance.
---> Highlighting a misleading metric as a surrogate for revenue.
---> Highlighting a misleading metric as a surrogate for earnings.
---> Highlighting a misleading metric as a surrogate for cash flow.
2. Distorting balance sheet metrics to avoid showing deterioration.
---> Distorting accounts receivable metrics to hide revenue problems.
---> Distorting inventory metrics to hide profitability problems.
---> Distorting financial asset metrics to hide impairment problems.
---> Distorting debt metrics to hide liquidity problems.
Notes to Financial Statements
Because of the complexities related to financial reporting and because of the number of alternative generally accepted accounting principles that can be used, notes to the financial statements are included as an integral part of the financial statements.
- The explanatory notes are an integral part of the financial statements; the notes provide detailed disclosure of information needed by users wishing to gain a full understanding of the financial statements.
- A summary of significant accounting policies is a required disclosure.
- The impact of various depreciation methods (units-of-production, declining-balance, straight-line, and sum-of-the-years'-digits) on reported income must be disclosed.
---> Disclosure of the depreciation method permits informed readers to make comparisons of companies in the same industry.
- Basis of Consolidation
- A reconciliation of the statutory income tax rate with the effective tax rate is another required disclosure
- The cost of employee benefit plans included as an expense in the income statement is disclosed
Typical accounting policies that are disclosed in the notes to the financial statements:
1. Depreciation method used
2. Inventory valuation method used
3. Basis of consolidation of subsidiaries
4. Reconciliation of taxes paid to tax expense
5. The cost of employee benefit plans
6. Treatment of goodwill and acquisition-related intangible assets
7. Details related to earnings per share
8. Stock option and stock purchase plans
- units-of-production method
- declining-balance method
- straight-line method
- sum-of-the-years'-digits method
FIFO, LIFO, and weighted-average inventory valuation methods have an impact on the income statement and the balance sheet.
- The selection of an inventory valuation method influences the reported income and the inventory amount shown on the balance sheet.
Basis of Consolidation
The basis of consolidation disclosure requires that consolidated financial statements include data from all substantial subsidiary companies.
A reconciliation of the statutory income tax rate with the effective tax rate is another required disclosure.
- GAAP is the set of rules for preparing financial statements; GAAP results in financial statement income tax expense.
- The Internal Revenue Code is the set of rules for preparing tax returns; the IRS Code results in income taxes payable.
- Income tax expense usually does not equal income tax payable; hence, such a reconciliation is needed by users.
- The cost of employee benefit plans included as an expense in the income statement is disclosed.
- Projected benefit obligation, accumulated benefit obligation, and vested benefit obligation are required explanatory note disclosures.
- An additional schedule is provided to show the components of net pension expense (income) for each of the past three years if this amount is material.
---> Several elements of pension expense (income) will be reported, including the service cost, interest cost of the projected benefit obligation, and the expected return on plan assets.
Projected benefit obligations
the present value of additional benefits related to projected pay increases
Accumulated benefit obligation
the present value of nonvested benefits at present pay levels
Vested Benefit Obligation
the present value of benefits at present pay levels
Intangibles Including Goodwill
When the balance sheet contains intangible assets, including goodwill arising from business acquisitions, trademarks, copyrights, and patents, the method of recognizing initial cost will be described.
- Any amortization or impairment in value of the intangibles must be shown.
Earnings Per Share of Common Stock
An explanation of the calculation will be provided, perhaps including details of the calculation of the weighted-average number of shares outstanding and the adjustments to net income for preferred stock dividends.
Stock Purchase Plan
Under a stock purchase plan, employees can purchase shares of their company's common stock at a slight discount from market value.
- The objective is to permit the employees to become part owners of the firm and thus to have more of an owner's attitude about their jobs and the company.
- Stock purchase plans are also accounted for under the fair value method.
Stock Option Plan
Many firms have a stock option plan under which directors, officers, and key employees are given an option to buy a certain number of shares of stock at some time in the future but at a price equal to the market value of the stock when the option is granted.
1. Accounting changes
2 .Business combinations:
---> If the firm has been involved in a business combination, the transactions involved will be described and the effect on the financial statements will be explained.
3. Contingencies and commitments:
---> It is not unusual for a firm to be involved in litigation, the results of which are not known when the financial statements are prepared. If the firm is denying liability in a lawsuit in which it is a defendant, it is appropriate to disclose the fact of the lawsuit to readers of the financial statements.
4. Events subsequent to the balance sheet date:
---> If, subsequent to the balance sheet date, a significant event occurs that has a material impact on the balance sheet or income statement, it is appropriate to provide an explanation of the probable impact of the subsequent event on future financial statements.
5. Impact of inflation
---> The FASB encourages, but does not require, companies to provide supplementary information on the effects of changing prices (inflation) in the notes to the financial statements. In practice, very few companies voluntarily do so.
6. Segment information:
---> The required disclosure of segment, geographic, and major customer information is designed to permit the financial statement user to make judgments about the impact on the firm of factors that might influence specific lines of business, geographic areas, or specific major customers.
Accounting change (other disclosures)
a change in the application of an accounting principle that has a material effect on the comparability of the current period financial statements with those of prior periods.
- The effects of recently adopted accounting changes must be disclosed.
- Sometimes accounting changes are the result of recent FASB codification updates.
---> Some of the most common changes reported by U.S. companies in recent years involved the accounting for business combinations, non-controlling interests, fair value measurements, leases, and revenue recognition issues.
Business Combination (other disclosures)
a merger, acquisition, or disposition
- Mergers and acquisitions are accounted for using the acquisition method.
---> Under the acquisition method, the net assets acquired are recorded by the acquiring company at their fair value at the date of acquisition.
---> Any amount paid for the acquired net assets (or company) in excess of the fair value of the net assets is recorded as goodwill.
a group of the firm's business activities that has a common denominator.
- Segments may reflect the company's organizational structure, manufacturing processes, product line groups, or industries served.
- The required disclosure of segment, geographic, and major customer information is designed to permit the financial statement user to make judgments about the impact on the firm of factors that might influence specific lines of business, geographic areas, or specific major customers.
Details of Financial Amounts
- Many firms will include in the notes to the financial statements the details of amounts that are reported as a single item in the financial statements.
---> Long-term debt, frequently reported as a single amount on the balance sheet, is usually made up of several obligations.
---> A descriptive listing of the obligations, including a schedule of the principal payments required for each of the next five years, is a mandatory reporting requirement if the amounts involved are material.
- The extent of such detail to be reported is decided by the financial officers of the firm and is generally based on their judgment of the benefit of such detail to the broad user audience that will receive the financial statements.
Contingencies (other disclosures)
an event that has an uncertain but potentially significant effect on the financial statements.
- If the firm is denying liability in a lawsuit in which it is a defendant, it is appropriate to disclose the fact of the lawsuit to readers of the financial statements.
- An expense or a loss and a related liability should be reported in the period affected. Even if the lawsuit is one that management and legal counsel believe will not result in any liability to the company, the fact of the potential loss and liability should be disclosed.
- The nature of the legal action, the potential damages, and a statement to the effect that the claims against the company are not likely to be sustained are included in the notes.
Commitments (other disclosures)
If the firm has made commitments to purchase a significant amount of plant and equipment or has committed to pay significant amounts of rent on leased property for several years into the future, these commitments will be disclosed.
- This is done because the commitment is like a liability but is not recorded on the balance sheet because the actual purchase transaction has not yet occurred.
Events Subsequent to the Balance Sheet Date (other disclosures)
- Subsequent events are events that happen after the close of the current year, but prior to the year-end statements being issued, which could have an impact on the current year statements.
- Some significant events that occur in the subsequent period (next year) may be required to be included in the current year statements, while other events may be disclosed in the notes.
- Examples of such significant events include the issuance of a large amount of long-term debt, the restructuring of long-term debt, the issuance of a large amount of capital stock, the sale of a significant part of the company's assets, and the agreement to enter into a business combination.
Impact of Inflation (Other Disclosures)
- Reporting the effects of inflation is a controversial and complex area of accounting. - Currently, the FASB encourages, but does not require, companies to provide supplementary information on the effects of changing prices (inflation) in the notes to the financial statements.
---> In practice, very few companies voluntarily do so.
---> Most companies discuss inflation briefly in their Management's Discussion and Analysis (MD&A) section of the 10-K but do not provide specific financial data.
- If the economy experiences high rates of inflation in the future, the present SEC disclosure requirements are likely to be reexamined and enhanced.
Segment Information (other disclosures)
Most large corporations operate in several lines of business and operate in many geographical areas.
- Segment information should include sales to:
---> unaffiliated customers
---> operating profit
---> capital expenditures
---> depreciation expense
---> identifiable assets
- Instead of an annual report, companies that are registered with the SEC file an annual informational report referred to as Form 10-K.
---> The Form 10-K includes information provided in a company's annual report and related note disclosures and some information usually not found in financial statements, such as data about executive compensation and ownership of voting stock by directors and officers.
---> It must also comply with additional SEC reporting requirements.
- Securities issued by corporations (principally stocks and bonds) that are offered for sale to more than a very few investors must be registered with the SEC.
Management's Statement of Responsibility
Many firms include in the notes management's statement of responsibility, which explains that the responsibility for the financial statements lies with the management of the firm, not the external auditor and certified public accountants who express an opinion about the fairness with which the financial statements present the financial condition and results of operations of the company.
Management Discussion & Analysis (MD&A)
A corporation is required to include a section called "Management Discussion and Analysis of Financial Condition and Results of Operations" in its annual report.
- Of particular interest to investors and potential investors are disclosures often provided in MD&A concerning non-GAAP financial measures and key performance indicators that are used to assess the company's financial and operating results.
Five-Year (or longer) Summary of Financial Data
Most corporate annual reports present a summary of financial data for at least the five most recent years. This information includes key income statement data, significant ratios, earnings and dividends per share, the average number of shares outstanding each year, year-end data from the balance sheet, book value per share of common stock, and the year-end market price of common stock.
- The five-year (or longer) summary is not included in the scope of the independent auditors' work, nor does their opinion relate to the summary.
---> It is a supplementary disclosure that may appear before or after the financial statements and notes.
Independent Auditor's Report
The format of the independent auditors' report contains four paragraphs:
---> internal control effectiveness
- Occasionally the auditors' report includes additional language and/or an explanatory paragraph that describes a situation that does not affect fair presentation but that should be disclosed to keep the financial statements from being misleading.
---> It is appropriate for the financial statement reader to review the independent auditors' report and determine the effect of any departure from the standard report.
Introductory paragraph (independent auditor's report)
describes the financial statements audited and states that management is responsible for the financial statements and that the auditors' task is to express an opinion about the financial statements.
Scope paragraph (independent auditor's report)
describes the nature and extent of the auditor's work, the audit process.
- The auditors' concern is with obtaining reasonable assurance about whether the financial statements are free of material misstatements and that their work involves tests.
Opinion paragraph (independent auditor's report)
Auditors express an opinion on the fairness of the financial presentation.
- Corporations wish to receive an unqualified report.
Internal Control Effectiveness & Nature of Opinion paragraph (independent auditor's report)
As required by the Public Company Accounting Oversight Board (PCAOB), an internal control audit is conducted in conjunction with the audit of financial statements, and an internal control audit opinion is presented on a separate page following the financial statements audit opinion.
For companies that are not registered with the SEC and do not have publicly traded securities, accountants may provide a service by compiling financial statements.
- A compilation is presenting, in the form of financial statements, information that has been prepared by management.
- A compilation report does not provide any assurance from the auditors about the fairness of the financial information.
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