Mensur Boydaş, Vahdi Boydaş: Accounting Principles: Ch24

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Mensur Boydaş, Vahdi Boydaş: Accounting Principles: Mensur Boydaş, Vahdi Boydaş: Accounting Principles: Mensur Boydaş, Vahdi Boydaş: Accounting Principles:

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Mensur Boydaş, Vahdi Boydaş: Accounting Principles: Ch24

  1. 1. C H A P T E R 24 FU LL D ISC LOSU R E I N FI NANC IAL R EPORTI NG LEARNING OBJECTIVES After studying this chapter, you should be able to: •1 Review the full disclosure principle and describe implementation problems. •2 Explain the use of notes in financial statement preparation. •3 Discuss the disclosure requirements for major business segments. •4 Describe the accounting problems associated with interim reporting. •5 Identify the major disclosures in the auditor’s report. •6 Understand management’s responsibilities for financials. •7 Identify issues related to financial forecasts and projections. •8 Describe the profession’s response to fraudulent financial reporting. Here are excerpts from leading experts regarding the importance of high-quality financial reporting: Warren E. Buffett, Chairman and Chief Executive Officer, Berkshire Hathaway Inc.: Financial reporting for Berkshire Hathaway, and for me personally, is the beginning of every decision that we make around here in terms of capital. I’m punching out 10-Ks and 10-Qs every single day. We look at the numbers and try to evaluate the quality of the financial reporting, and then we try to figure out what that means for the bonds and stocks that we’re looking at, and thinking of either buying or selling. Judy Lewent, Executive Vice President and Chief Financial Officer, Merck & Co., Inc. . . . Higher standards, when properly implemented, drive excellence. I can make a parallel to the pharmaceutical industry. If you look around the world at where innovations come from, economists have studied and seen that where regulatory standards are the highest is where innovation is also the highest. Floyd Norris, Chief Financial Correspondent, the New York Times: We are in a situation now in our society where the temptations to provide “bad” financial reporting are probably greater than they used to be. The need to get the stock price up, or to keep it up, is intense. So, the temptation to play games, the temptation to manage earnings—some of which can be legitimate and some of which cannot be—is probably greater than it used to be. High-Quality Financial Reporting—Always in Fashion 1312 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  2. 2. Abby Joseph Cohen, Chair, Investment Policy Committee, Goldman, Sachs & Co.: High-quality financial reporting is perhaps the most important thing we can expect from companies. For investors to make good decisions—whether those investors are buying stocks or bonds or making private investments—they need to know the truth. And we think that when information is as clear as possible and is reported as frequently as makes sense, investors can do their jobs as best they can. We can also get insight into the importance of high-quality reporting based on the market assessment of companies perceived to have poorquality reporting. In a recent quarter, Coach, Inc. stopped reporting as sepDOLLARS 55 arate items sales from regular stores (full price) and factory outlets. As a result, readers of its financial statements have a hard time determining the 50 Coach source of Coach’s sales growth. Analysts are especially concerned that the Stock Price 45 less-transparent reporting may obscure slowing sales at its regular stores, as consumers cut down on luxury goods in the sluggish economy. Did 40 Coach’s stock price suffer as a result of this lower-quality reporting? You 35 bet, as shown in the price graph on the right. 30 Since the change in reporting in 2007, Coach’s stock price has been down 34 percent. As one analyst noted, “It’s never a good sign when you 0 MAY ’07 MAY ’08 reduce transparency . . . It’s a sign of weakness.” Data: Bloomberg Financial Markets In short, the analysts’ comments above illustrate why high-quality reporting is always in fashion—for companies, investors, and the capital markets. And, as the Coach example illustrates, full disclosure is at the heart of high-quality reporting. Out of Fashion Sources: Excerpts taken from video entitled “Financially Correct with Ben Stein,” Financial Accounting Standards Board (Norwalk, Conn.: FASB, 2002). By permission. See also J. Porter, “As Belts Tighten, Coach Feels the Pinch,” BusinessWeek (May 29, 2008), p. 66. PR EVI EW OF C H A PTER 24 As the opening story indicates, our markets will not function properly without transparent, complete, and truthful reporting of financial performance. Investors and other interested parties need to read and understand all aspects of financial reporting—the financial statements, the notes, the president’s letter, and management’s discussion and analysis. In this chapter, we cover the full disclosure principle in more detail and examine disclosures that must accompany financial statements so that they are not misleading. The content and organization of this chapter are as follows. FULL DISCLOSURE IN FINANCIAL REPORTING FULL DISCLOSURE PRINCIPLE • Increase in reporting requirements • Differential disclosure NOTES TO FINANCIAL S TAT E M E N T S • Accounting policies • Common notes DISCLOSURE ISSUES • Special transactions or events • Post-balance-sheet events AUDITOR’S AND MANAGEMENT’S REPORTS • Auditor’s report • Management’s reports CURRENT REPORTING ISSUES • Reporting on forecasts and projections • Internet financial reporting • Diversified companies • Fraudulent financial reporting • Interim reports • Criteria for accounting and reporting choices 1313 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  3. 3. 1314 · Chapter 24 Full Disclosure in Financial Reporting FULL DISCLOSURE PRINCIPLE FASB Concepts Statement No. 1 notes that some useful information is best provided in the financial statements, and some is best provided by means other than in financial statements. For example, earnings and cash flows are readily available in financial statements—but investors might do better to look at comparisons to other companies in the same industry, found in news articles or brokerage house reports. FASB rules directly affect financial statements, notes to the financial stateObjective•1 ments, and supplementary information. Other types of information found in Review the full disclosure principle the annual report, such as management’s discussion and analysis, are not and describe implementation subject to FASB rules. Illustration 24-1 indicates the various types of financial problems. information. All Information Useful for Investment, Credit, and Similar Decisions Financial Reporting Area Directly Affected by Existing FASB Rules Basic Financial Statements Financial Statements • Balance Sheet • Income Statement • Statement of Cash Flows • Statement of Changes in Stockholders' Equity Notes to the Financial Statements Examples: • Accounting Policies • Contingencies • Inventory Methods • Number of Shares of Stock Outstanding • Alternative Measures (fair values of items carried at historical cost) Supplementary Information Examples: • Changing Prices Disclosures • Oil and Gas Reserves Information Other Means of Financial Reporting Examples: • Management’s Discussion and Analysis • Letters to Stockholders Other Information Examples: • Discussion of Competition and Order Backlog in SEC Forms • Analysts' Reports • Economic Statistics • News Articles about Company ILLUSTRATION 24-1 Types of Financial Information As Chapter 2 indicated, the profession has adopted a full disclosure principle. The full disclosure principle calls for financial reporting of any financial facts significant enough to influence the judgment of an informed reader. In some situations, the benefits of disclosure may be apparent but the costs uncertain. In other instances, the costs may be certain but the benefits of disclosure not as apparent. For example, recently, the SEC required companies to provide expanded disUnderlying Concepts closures about their contractual obligations. In light of the off-balance-sheet Here is a good example of the tradeaccounting frauds at companies like Enron, the benefits of these expanded disoff between cost considerations and closures seem fairly obvious to the investing public. While no one has docuthe benefits of full disclosure. mented the exact costs of disclosure in these situations, they would appear to be relatively small. On the other hand, the cost of disclosure can be substantial in some cases and the benefits difficult to assess. For example, at one time the Wall Street Journal reported that if segment reporting were adopted, a company like Fruehauf would have had to increase its accounting staff 50 percent, from 300 to 450 individuals. In this case, the cost of disclosure can be measured, but the benefits are less well defined. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  4. 4. Full Disclosure Principle · 1315 Some even argue that the reporting requirements are so detailed and substantial that users have a difficult time absorbing the information. These critics charge the profession with engaging in information overload. Financial disasters at Microstrategy, PharMor, WorldCom, and AIG highlight the difficulty of implementing the full disclosure principle. They raise the issue of why investors were not aware of potential problems: Was the information these companies presented not comprehensible? Was it buried? Was it too technical? Was it properly presented and fully disclosed as of the financial statement date, but the situation later deteriorated? Or was it simply not there? In the following sections, we describe the elements of high-quality disclosure that will enable companies to avoid these disclosure pitfalls. Underlying Concepts The AICPA’s Special Committee on Financial Reporting notes that business reporting is not free, and improving it requires considering the relative costs and benefits of information. Undisciplined expansion of mandated reporting could result in large and needless costs. Increase in Reporting Requirements Disclosure requirements have increased substantially. One survey showed that the size of many companies’ annual reports is growing in response to demands for increased transparency. For example, annual report page counts ranged from 70 pages for Gateway up to a whopping 244 pages in Eastman Kodak’s annual report. Compared to prior years’ reports, the percentage increase in pages ranged from 17 percent at IBM to over 80 percent at Siebel Systems.1 This result is not surprising; as illustrated throughout this textbook, the FASB has issued many pronouncements in the last 10 years that have substantial disclosure provisions. The reasons for this increase in disclosure requirements are varied. Some of them are: Complexity of the Business Environment. The increasing complexity of business operations magnifies the difficulty of distilling economic events into Underlying Concepts summarized reports. Such areas as derivatives, leasing, business combina- The AICPA’s Special Committee on tions, pensions, financing arrangements, revenue recognition, and deferred Financial Reporting states that to taxes are complex. As a result, companies extensively use notes to the finan- meet users’ changing needs, busicial statements to explain these transactions and their future effects. ness reporting must: (1) Provide Necessity for Timely Information. Today, more than ever before, users are more forward-looking information. demanding information that is current and predictive. For example, users (2) Focus more on the factors that want more complete interim data. Also, the SEC recommends published fi- create longer-term value, including nonfinancial measures. (3) Better align nancial forecasts, long avoided and even feared by management. information reported externally with Accounting as a Control and Monitoring Device. The government has re- the information reported internally. cently sought public disclosure of such phenomena as management compensation, off-balance-sheet financing arrangements, and related party transactions. An “Enronitis” concern is expressed in many of these newer disclosure requirements, and the SEC has selected accountants and auditors as the agents to assist in controlling and monitoring these concerns. Differential Disclosure A trend toward differential disclosure is also occurring. For example, the SEC requires that companies report to it certain substantive information that is not found in annual reports to stockholders. Likewise, the FASB, recognizing that certain disclosure requirements are costly and unnecessary for certain companies, has eliminated reporting requirements for nonpublic enterprises in such areas as fair value of financial instruments and segment reporting.2 1 Aliya Sternstein, “Heavy Lifting Required,” Forbes (October 13, 2003) p. 58. 2 The FASB has had a disclosure-effectiveness project. The revised pension and postretirement benefit disclosures discussed in Chapter 20 are one example of how disclosures can be streamlined and made more useful. However, as noted by one FASB member, the usefulness of expanded required disclosure also depends on users’ ability to distinguish between disclosed versus recognized items in financial statements. Research to date is inconclusive on this matter. See Katherine Schipper, “Required Disclosures in Financial Reports,” Presidential Address to the American Accounting Association Annual Meeting; San Francisco, CA (August 2005). PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  5. 5. 1316 · Chapter 24 Full Disclosure in Financial Reporting “THE HEART OF THE MATTER” What do the numbers mean? As we discussed in the opening story, financial disclosure is one of a number of institutional features that contribute to vibrant security markets. In fact, a recent study of disclosure and other mechanisms (such as civil lawsuits and criminal sanctions) found that good disclosure is the most important contributor to a vibrant market. The study, which compared disclosure and other legal and regulatory elements across 49 countries, found that countries with the best disclosure laws have the biggest stock markets. Countries with more successful market environments also tend to have regulations that make it relatively easy for private investors to sue corporations that provide bad information. That is, while criminal sanctions can be effective in some circumstances, disclosure and other legal and regulatory elements encouraging good disclosure are the most important determinants of highly liquid and deep securities markets. These findings hold for nations in all stages of economic development, with particular importance for nations that are in the early stages of securities regulation. The lesson: Disclosure is good for your market. Source: Rebecca Christie, “Study: Disclosure at Heart of Effective Securities Laws,” Wall Street Journal Online (August 11, 2003). Underlying Concepts The AICPA Special Committee on Financial Reporting indicated that users differ in their needs for information and that not all companies should report all elements of information. Rather, companies should report only information that users and preparers agree is needed in the particular circumstances. Some still complain that the FASB has not gone far enough. They note that certain types of companies (small or nonpublic) should not have to follow complex GAAP requirements such as those for deferred income taxes, leases, or pensions. This issue, often referred to as “big GAAP versus little GAAP,” continues to be controversial. The FASB takes the position that there should be one set of GAAP, except in unusual situations.3 NOTES TO THE FINANCIAL STATEMENTS As you know from your study of this textbook, notes are an integral part of the financial statements of a business enterprise. However, readers of financial statements often overlook them because they are highly technical and often appear Objective•2 in small print. Notes are the means of amplifying or explaining the items preExplain the use of notes in sented in the main body of the statements. They can explain in qualitative terms financial statement preparation. information pertinent to specific financial statement items. In addition, they can provide supplementary data of a quantitative nature to expand the information in the financial statements. Notes also can explain restrictions imposed by financial arrangements or basic contractual agreements. Although notes may be technical and difficult to understand, they provide meaningful information for the user of the financial statements. Accounting Policies Accounting policies are the specific accounting principles and methods a company currently uses and considers most appropriate to present fairly its financial statements. GAAP 3 In response to cost-benefit concerns, the SEC has exempted some small public companies from certain rules implemented in response to the Sarbanes-Oxley Act of 2002. For example, smaller companies have more time to comply with the internal control rules required by the Sarbanes-Oxley law and have more time to file annual and interim reports. Both the FASB and the AICPA are studying the big GAAP/little GAAP issue to ensure that any kind of differential reporting is conceptually sound and meets the needs of users. See Remarks of Robert H. Herz, Chairman, Financial Accounting Standards Board, 2004 AICPA National Conference on Current SEC and PCAOB Reporting Developments (December 7, 2004). PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  6. 6. Notes to the Financial Statements · 1317 states that information about the accounting policies adopted by a reporting entity is essential for financial statement users in making economic decisions. It recommended that companies should present as an integral part of the financial statements a statement identifying the accounting policies adopted and followed by the reporting entity. Companies should present the disclosure as the first note or in a separate Summary of Significant Accounting Policies section preceding the notes to the financial statements. The Summary of Significant Accounting Policies answers such questions as: What method of depreciation is used on plant assets? What valuation method is I NTERNATIONAL employed on inventories? What amortization policy is followed in regard to in- I NSIGHT tangible assets? How are marketing costs handled for financial reporting purposes? iGAAP has a project that is Refer to Appendix 5B, pages 210–238, for an illustration of note disclosure of considering different accounting rules for small- and medium-sized accounting policies (Note 1) and other notes accompanying the audited financial enterprises. statements of The Procter & Gamble Company. Illustration 24-2 shows another example, from Tootsie Roll Industries. Tootsie Roll Industries, Inc. and Subsidiaries (Dollars in thousands, except per share amounts) ILLUSTRATION 24-2 Note Disclosure of Accounting Policies Note 1—Significant Accounting Policies (in part) Basis of consolidation The consolidated financial statements include the accounts of Tootsie Roll Industries, Inc. and its whollyowned subsidiaries (the Company), which are primarily engaged in the manufacture and sale of candy products. All significant intercompany transactions have been eliminated. The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expense during the reporting period. Actual results could differ from those estimates. Certain reclassifications have been made to the prior year financial statements to conform to the current year presentation. Revenue recognition Products are sold to customers based on accepted purchase orders which include quantity, sales price and other relevant term of sale. Revenue, net of applicable provisions for discounts, returns, allowances, and certain advertising and promotional costs, is recognized when products are delivered to customers and collectibility is reasonably assured. Shipping and handling costs of $41,775, $40,353 and $37,836 in 2007, 2006 and 2005, respectively, are included in selling, marketing and administrative expenses. Accounts receivable are unsecured. Revenues from a major customer aggregated approximately 22.4%, 23.7% and 24.0% of net product sales during the years ended December 31, 2007, 2006 and 2005, respectively. . . . Cash and cash equivalents The Company considers temporary cash investments with an original maturity of three months or less to be cash equivalents. Investments Investments consist of various marketable securities with maturities of generally up to four years. The Company classifies debt and equity securities as either available for sale or trading. Available for sale are not actively traded and are carried at fair value. Unrealized gains and losses on these securities are excluded from earnings and are reported as a separate component of shareholders’ equity, net of applicable taxes, until realized. Trading securities relate to deferred compensation arrangements and are carried at fair value. The Company invests in trading securities to hedge changes in its deferred compensation liabilities. Hedging activities From time to time, the Company enters into commodities futures contracts that are intended and effective as hedges of market price risks associated with the anticipated purchase of certain raw materials (primarily sugar). To qualify as a hedge, the Company evaluates a variety of characteristics of these transactions, including the probability that the anticipated transaction will occur. If the anticipated transaction were not to occur, the gain or loss would then be recognized in current earnings. The Company does not engage in trading or other speculative use of derivative instruments. The Company does assume the risk that counter parties may not be able to meet the terms of their contracts. The Company does not expect any losses as a result of counter party defaults. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  7. 7. 1318 · Chapter 24 Full Disclosure in Financial Reporting The Company’s commodities futures contracts are being accounted for as cash flow hedges and are recorded on the balance sheet at fair value. Changes therein are recorded in other comprehensive earnings and are reclassified to earnings in the periods in which earnings are affected by the hedged item. Substantially all amounts reported in accumulated other comprehensive earnings (loss) are expected to be reclassified to cost of goods sold. Inventories Inventories are stated at cost, not to exceed market. The cost of substantially all of the Company’s inventories ($54,367 and $61,092 at December 31, 2007 and 2006, respectively) has been determined by the last-in, first-out (LIFO) method. The excess of current cost over LIFO cost of inventories approximates $11,284 and $7,350 at December 31, 2007 and 2006, respectively. The cost of certain foreign inventories ($3,036 and $2,865 at December 31, 2007 and 2006, respectively) has been determined by the first-in, first-out (FIFO) method. Rebates, discounts and other cash consideration received from a vendor related to inventory purchases is reflected as a reduction in the cost of the related inventory item, and is therefore reflected in cost of sales when the related inventory item is sold. Property, plant and equipment Depreciation is computed for financial reporting purposes by use of the straight-line method based on useful lives of 20 to 35 years for buildings and 5 to 20 years for machinery and equipment. Depreciation expense was $15,859, $15,816, and $14,687 in 2007, 2006 and 2005, respectively. Carrying value of long-lived assets The Company reviews long-lived assets to determine if there are events or circumstances indicating that the amount of the asset reflected in the Company’s balance sheet may not be recoverable. When such indicators are present, the Company compares the carrying value of the long-lived asset, or asset group, to the future undiscounted cash flows of the underlying assets to determine if an impairment exists. If applicable, an impairment charge would be recorded to write down the carrying value to its fair value. The determination of fair value involves the use of estimates of future cash flows that involve considerable management judgment and are based upon assumptions about expected future operating performance. The actual cash flows could differ from management’s estimates due to changes in business conditions, operating performance, and economic conditions. No impairment charges were recorded by the Company during 2007, 2006 or 2005. Postretirement health care and life insurance benefits The Company provides certain postretirement health care and life insurance benefits. The cost of these postretirement benefits is accrued during employees’ working careers. The Company also provides split dollar life insurance benefits to certain executive officers. The Company records an asset equal to the cumulative insurance premiums that will be recovered upon the death of a covered employee(s) or earlier under the terms of the plan. Split dollar premiums paid were $1,586, $3,002, and $3,678 in 2007, 2006 and 2005, respectively. Goodwill and intangible assets The Company accounts for intangible assets in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” In accordance with this statement, goodwill and intangible assets with indefinite lives are not amortized, but rather tested for impairment at least annually. All trademarks have been assessed by management to have indefinite lives because they are expected to generate cash flows indefinitely. The Company has completed its annual impairment testing of its goodwill and trademarks during the fourth quarter of each of the years presented, and recorded an impairment of $4,743 in the fourth quarter of 2005 relating to a minor trademark and related goodwill. No impairments were recorded in either 2007 or 2006. Income taxes Deferred income taxes are recorded and recognized for future tax effects of temporary differences between financial and income tax reporting. The Company records valuation allowances in situations where the realization of deferred tax assets is not likely. Federal income taxes are provided on the portion of income of foreign subsidiaries that is expected to be remitted to the U.S. and become taxable, but not on the portion that is considered to be permanently invested in the foreign subsidiary. Foreign currency translation The Company has determined the functional currency for each foreign subsidiary. The U.S. dollar is used as the functional currency where a substantial portion of the subsidiary’s business is indexed to the U.S. dollar or where its manufactured products are principally sold in the U.S. All other foreign subsidiaries use the local currency as their functional currency. Where the U.S. dollar is used as the functional currency, foreign currency translation adjustments are recorded as a charge or credit to other income in the statement of earnings. Where the foreign currency is used as the functional currency, translation adjustments are recorded as a separate component of comprehensive earnings (loss). Joint venture The Company’s 50% interest in two companies is accounted for using the equity method. The Company records an increase in its investment in the joint venture to the extent of its share of the joint venture’s earnings, and reduces its investment to the extent of dividends received. Dividends of $861, $1,946 and PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  8. 8. Notes to the Financial Statements · 1319 $651 were paid in 2007, 2006 and 2005, respectively, by the joint venture. The $1,946 dividend declared in 2006 was not received by the Company until after December 31, 2006; this amount is included in other receivables at December 31, 2006. Comprehensive earnings Comprehensive earnings includes net earnings, foreign currency translation adjustments and unrealized gains/losses on commodity hedging contracts, available for sale securities and certain postretirement benefit obligations. Earnings per share A dual presentation of basic and diluted earnings per share is not required due to the lack of potentially dilutive securities under the Company’s simple capital structure. Therefore, all earnings per share amounts represent basic earnings per share. Analysts examine carefully the summary of accounting policies to determine whether a company is using conservative or liberal accounting practices. For example, depreciating plant assets over an unusually long period of time is considered liberal. Using LIFO inventory valuation in a period of inflation is generally viewed as conservative. Companies that fail to adopt high-quality reporting policies may be heavily penalized by the market. For example, when Microstrategy disclosed that it would restate prior-year results due to use of aggressive revenue recognition policies, its share price dropped over 60 percent in one day. Investors viewed Microstrategy’s quality of earnings as low. Common Notes We have discussed many of the notes to the financial statements throughout this textbook, and will discuss others more fully in this chapter. The more common are as follows. MAJOR DISCLOSURES INVENTORY. Companies should report the basis upon which inventory amounts are stated (lower-of-cost-or-market) and the method used in determining cost (LIFO, FIFO, average cost, etc.). Manufacturers should report, either in the balance sheet or in a separate schedule in the notes, the inventory composition (finished goods, work in process, raw materials). Unusual or significant financing arrangements relating to inventories that may require disclosure include transactions with related parties, product financing arrangements, firm purchase commitments, involuntary liquidation of LIFO inventories, and pledging of inventories as collateral. Chapter 9 (pages 457–459) illustrates these disclosures. PROPERTY, PLANT, AND EQUIPMENT. Companies should state the basis of valuation for property, plant, and equipment. It is usually historical cost. Companies also should disclose pledges, liens, and other commitments related to these assets. In the presentation of depreciation, companies should disclose the following in the financial statements or in the notes: (1) depreciation expense for the period; (2) balances of major classes of depreciable assets, by nature and function, at the balance sheet date; (3) accumulated depreciation, either by major classes of depreciable assets or in total, at the balance sheet date; and (4) a general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets. Finally, companies should explain any major impairments. Chapter 11 (pages 559–560) illustrates these disclosures. CREDITOR CLAIMS. Investors normally find it extremely useful to understand the nature and cost of creditor claims. However, the liabilities section in the PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  9. 9. 1320 · Chapter 24 Full Disclosure in Financial Reporting balance sheet can provide the major types of liabilities only in the aggregate. Note schedules regarding such obligations provide additional information about how a company is financing its operations, the costs that it will bear in future periods, and the timing of future cash outflows. Financial statements must disclose for each of the five years following the date of the statements the aggregate amount of maturities and sinking fund requirements for all long-term borrowings. Chapter 14 (pages 711–712) illustrates these disclosures. EQUITY HOLDERS’ CLAIMS. Many companies present in the body of the balance sheet information about equity securities: the number of shares authorized, issued, and outstanding and the par value for each type of security. Or, companies may present such data in a note. Beyond that, a common equity note disclosure relates to contracts and senior securities outstanding that might affect the various claims of the residual equity holders. An example would be the existence of outstanding stock options, outstanding convertible debt, redeemable preferred stock, and convertible preferred stock. In addition, it is necessary to disclose certain types of restrictions currently in force. Generally, these types of restrictions involve the amount of earnings available for dividend distribution. Examples of these types of disclosures are illustrated in Chapter 15 (pages 765–766) and Chapter 16 (pages 821–822). CONTINGENCIES AND COMMITMENTS. A company may have gain or loss contingencies that are not disclosed in the body of the financial statements. These contingencies include litigation, debt and other guarantees, possible tax assessments, renegotiation of government contracts, and sales of receivables with recourse. In addition, companies should disclose in the notes commitments that relate to dividend restrictions, purchase agreements (through-put and take-orpay), hedge contracts, and employment contracts. Disclosures of such items are illustrated in Chapter 7 (page 343), Chapter 9 (pages 446–447), and Chapter 13 (pages 662–665). Underlying Concepts The AICPA Special Committee on Financial Reporting notes that standard-setters should address disclosures and accounting requirements for off-balance-sheet financial arrangements. The goal should be to report the risks, opportunities, resources, and obligations that result from those arrangements, consistent with users’ needs for information. FAIR VALUES. Companies that have assets or liabilities measured at fair value must disclose both the cost and the fair value of all financial instruments in the notes to the financial statements. Fair value measurements may be used for many financial assets and liabilities, investments, impairments of long-lived assets, and some contingencies. Companies also provide disclosure of information that enables users to determine the extent of usage of fair value and the inputs used to implement fair value measurement. This fair value hierarchy identifies three broad levels related to the measurement of fair values (Levels 1, 2, and 3). The levels indicate the reliability of the measurement of fair value information. An appendix to Chapter 17 (pages 905–908) discusses in detail fair value disclosures. DEFERRED TAXES, PENSIONS, AND LEASES. The FASB also requires extensive disclosure in the areas of deferred taxes, pensions, and leases. Chapter 19 (pages 1011–1015), Chapter 20 (pages 1069–1074), and Chapter 21 (pages 1146–1148) discuss in detail each of these disclosures. Users of financial statements should carefully read notes to the financial statements for information about off-balance-sheet commitments, future financing needs, and the quality of a company’s earnings. CHANGES IN ACCOUNTING PRINCIPLES. The profession defines various types of accounting changes and establishes guides for reporting each type. Companies discuss, either in the summary of significant accounting policies or in the other notes, changes in accounting principles (as well as material changes in estimates and corrections of errors). See Chapter 22 (pages 1191–1196). PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  10. 10. o y. c o m / FOOTNOTE SECRETS Often, note disclosures are needed to give a complete picture of a company’s financial position. A good example of such disclosures is the required disclosure of debt triggers that may be buried in financing arrangements. These triggers can require a company to pay off a loan immediately if the debt rating collapses; they are one of the reasons Enron crumbled so quickly. But few Enron stockholders knew about the debt triggers until the gun had gone off. Companies are also disclosing more about their bank credit lines, liquidity, and any special purpose entities. (The latter were major villains in the Enron drama.) How can you get better informed about note disclosures that may contain important information related to your investments? Beyond your study in this class, a good web resource for understanding the contents of note disclosures is http://www.footnoted.org/. This site highlights “the things companies bury in their SEC filings.” It notes that company reports are more complete of late, but only the largest companies are preparing documents that are readable. As the editor of the site noted, “[some companies] are being dragged kicking and screaming into plain English.” w co llege/k es ile In earlier chapters we discussed the disclosures listed above. The following sections of this chapter illustrate four additional disclosures of significance—special transactions or events, subsequent events, segment reporting, and interim reporting. i Disclosure Issues · 1321 Additional Examples of Major Disclosures What do the numbers mean? Source: Gretchen Morgenson, “Annual Reports: More Pages, But Better?” New York Times (March 17, 2002), and D. Stead, “The Secrets in SEC Filings,” BusinessWeek (August 25, 2008), p. 12. DISCLOSURE ISSUES Disclosure of Special Transactions or Events Related-party transactions, errors and fraud, and illegal acts pose especially sensitive and difficult problems. The accountant/auditor who has responsibility for reporting on these types of transactions must take care to properly balance the rights of the reporting company and the needs of users of the financial statements. Related-party transactions arise when a company engages in transactions in which one of the parties has the ability to significantly influence the policies of the other. They may also occur when a nontransacting party has the ability to influence the policies of the two transacting parties.4 Competitive, free-market dealings may not exist in relatedparty transactions, and so an “arm’s-length” basis cannot be assumed. Transactions such as borrowing or lending money at abnormally low or high interest rates, real estate sales at amounts that differ significantly from appraised value, exchanges of nonmonetary assets, and transactions involving enterprises that have no economic substance (“shell corporations”) suggest that related parties may be involved. In order to make adequate disclosure, companies should report the economic substance, rather than the legal form, of these transactions. GAAP requires the following disclosures of material related-party transactions. [1] See the FASB Codification section (page 1361). 1. The nature of the relationship(s) involved. 2. A description of the transactions (including transactions to which no amounts or nominal amounts were ascribed) for each of the periods for which income statements are presented. 4 Examples of related-party transactions include transactions between (a) a parent company and its subsidiaries; (b) subsidiaries of a common parent; (c) a company and trusts for the benefit of employees (controlled or managed by the enterprise); and (d) a company and its principal owners, management, or members of immediate families, and affiliates. Two classic cases of related-party transactions were Enron, with its misuse of special purpose entities, and Tyco International, which forgave loans to its management team. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  11. 11. 1322 · Chapter 24 Full Disclosure in Financial Reporting 3. The dollar amounts of transactions for each of the periods for which income statements are presented. 4. Amounts due from or to related parties as of the date of each balance sheet presented. Illustration 24-3, from the annual report of Harley-Davidson, Inc., shows disclosure of related-party transactions. ILLUSTRATION 24-3 Disclosure of RelatedParty Transactions Harley-Davidson, Inc. Note 12. Related Party Transactions The Company has the following material related party transactions. A director of the Company is Chairman and Chief Executive Officer and an equity owner of Fred Deeley Imports Ltd. (Deeley Imports), the exclusive distributor of the Company’s motorcycles in Canada. During 2007, 2006 and 2005, the Company recorded revenue and financial services income from Deeley Imports of $231.9 million, $187.7 million and $145.1 million, respectively, and had accounts receivables balances due from Deeley Imports of $42.6 million and $21.0 million at December 31, 2007 and 2006, respectively. All such products were provided in the ordinary course of business at prices and on terms and conditions that the Company believes are the same as those that would result from arm’s-length negotiations between unrelated parties. Many companies are involved in related-party transactions. Errors, fraud (sometimes referred to as irregularities), and illegal acts, however, are the exception rather than the rule. Accounting errors are unintentional mistakes, whereas fraud (misappropriation of assets and fraudulent financial reporting) involves intentional distortions of financial statements.5 As indicated earlier, companies should correct the financial statements when they discover errors. The same treatment should be given fraud. The discovery of fraud, however, gives rise to a different set of procedures and responsibilities for the accountant/auditor.6 Illegal acts encompass such items as illegal political contributions, bribes, kickbacks, and other violations of laws and regulations.7 In these situations, the accountant/ auditor must evaluate the adequacy of disclosure in the financial statements. For example, if a company derives revenue from an illegal act that is considered material in relation to the financial statements, this information should be disclosed. The SarbanesOxley Act of 2002 is intended to deter these illegal acts. This law adds significant fines and longer jail time for those who improperly sign off on the correctness of financial statements that include willing and knowing misstatements. Disclosure plays a very important role in these types of transactions because the events are more qualitative than quantitative and involve more subjective than objective evaluation. Users of the financial statements need some indication of the existence and nature of these transactions, through disclosures, modifications in the auditor’s report, or reports of changes in auditors. 5 “Consideration of Fraud in a Financial Statement Audit,” Statement on Auditing Standards No. 99 (New York, AICPA, 2002). We have an expanded discussion of fraudulent financial reporting later in this chapter. Since passage of the Sarbanes-Oxley Act of 2002, auditors of public companies are regulated by the Public Company Accounting Oversight Board (PCAOB). The PCAOB is now the audit standard-setter for auditors of public companies. It has adopted much of the prior auditing standards issued by the Auditing Standards Board of the AICPA. 6 The profession became so concerned with certain management frauds that affect financial statements that it established a National Commission on Fraudulent Financial Reporting. The major purpose of this organization was to determine how fraudulent reporting practices could be constrained. Fraudulent financial reporting is discussed later in this chapter. 7 “Illegal Acts by Clients,” Statement on Auditing Standards No. 54 (New York, AICPA, 1988). PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  12. 12. Disclosure Issues · 1323 Post-Balance-Sheet Events (Subsequent Events) Notes to the financial statements should explain any significant financial events that took place after the formal balance sheet date, but before the statement is issued. These events are referred to as post-balance-sheet events, or just plain subsequent events. Illustration 24-4 shows a time diagram of the subsequent events period. Balance Sheet Date Financial Statement Period Jan. 1, 2010 Financial Statements Issue Date ILLUSTRATION 24-4 Time Periods for Subsequent Events Subsequent Events Period Dec. 31, 2010 Mar. 3, 2011 A period of several weeks, and sometimes months, may elapse after the end of the fiscal year but before the company issues financial statements. Various activities involved in closing the books for the period and issuing the statements all take time: taking and pricing the inventory, reconciling subsidiary ledgers with controlling accounts, preparing necessary adjusting entries, ensuring that all transactions for the period have been entered, obtaining an audit of the financial statements by independent certified public accountants, and printing the annual report. During the period between the balance sheet date and its distribution to stockholders and creditors, important transactions or other events may occur that materially affect the company’s financial position or operating situation. Many who read a balance sheet believe the balance sheet condition is constant, and they project it into the future. However, readers must be told if the company has experienced a significant change—e.g., sold one of its plants, acquired a subsidiary, suffered extraordinary losses, settled significant litigation, or experienced any other important event in the post-balance-sheet period. Without an explanation in a note, the reader might be misled and draw inappropriate conclusions. Two types of events or transactions occurring after the balance sheet date Underlying Concepts may have a material effect on the financial statements or may need disclosure so The periodicity or time period that readers interpret these statements accurately: assumption implies that economic activities of an enterprise can be 1. Events that provide additional evidence about conditions that existed at the divided into artificial time periods for balance sheet date, including the estimates inherent in the process of prepar- purpose of analysis. ing financial statements. These events are referred to as recognized subsequent events and require adjustments to the financial statements. All information available prior to the issuance of the financial statements helps investors and creditors evaluate estimates previously made. To ignore these subsequent events is to pass up an opportunity to improve the accuracy of the financial statements. This first type of event encompasses information that an accountant would have recorded in the accounts had the information been known at the balance sheet date. For example, if a loss on an account receivable results from a customer’s bankruptcy subsequent to the balance sheet date, the company adjusts the financial statements before their issuance. The bankruptcy stems from the customer’s poor financial health existing at the balance sheet date. The same criterion applies to settlements of litigation. The company must adjust the financial statements if the events that gave rise to the litigation, such as personal injury or patent infringement, took place prior to the balance sheet date. 2. Events that provide evidence about conditions that did not exist at the balance sheet date but arise subsequent to that date. These events are referred as nonrecognized subsequent events and do not require adjustment of the financial statements. To illustrate, a loss resulting from a customer’s fire or flood after the balance sheet date does not reflect conditions existing at that date. Thus, adjustment of the financial PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  13. 13. 1324 · Chapter 24 Full Disclosure in Financial Reporting statements is not necessary. A company should not recognize subsequent events that provide evidence about conditions that did not exist at the date of the balance sheet but that arose after the balance sheet date. The following are examples of nonrecognized subsequent events: (a) Sale of a bond or capital stock issued after the balance sheet date. (b) A business combination that occurs after the balance sheet date. (c) Settlement of litigation when the event giving rise to the claim took place Underlying Concepts after the balance sheet date. A company also should consider (d) Loss of plant or inventories as a result of fire or natural disaster that occurred supplementing the historical financial after the balance sheet date. statements with pro forma financial (e) Losses on receivables resulting from conditions (such as a customer’s major data. Occasionally, a nonrecognized subsequent event may be so significasualty) arising after the balance sheet date. cant that disclosure can best be (f) Changes in the quoted market prices of securities or foreign exchange rates made by means of pro forma finanafter the balance sheet date. cial data. (g) Entering into significant commitments or contingent liabilities, for example, by issuing significant guarantees after the balance sheet date. [2]8 Some nonrecognized subsequent events may have to be disclosed to keep the financial statements from being misleading. For such events, a company discloses the nature of the event and an estimate of its financial effect. Illustration 24-5 presents an example of subsequent events disclosure, excerpted from the annual report of Masco Corporation. ILLUSTRATION 24-5 Disclosure of Subsequent Events Masco Corporation Note K (In Part): Debt Subsequent Event On January 20, 2007, holders of $1.8 billion (94 percent) principal amount at maturity of the Zero Coupon Convertible Senior Notes (“Notes”) required the Company to repurchase their Notes at a cash value of $825 million. As a result of this repurchase, a $93 million deferred income tax liability will be payable in June 2007. Subsequent to the repurchase, there were outstanding $108 million principal amount at maturity of such Notes, with an accreted value of $51 million, which has been included in long-term debt at December 31, 2006, as the next put option date is July 20, 2011. The Company may, at any time on or after January 25, 2007, redeem all or part of the Notes at their accreted value. Many subsequent events or developments do not require adjustment of or disclosure in the financial statements. Typically, these are nonaccounting events or conditions that management normally communicates by other means. These events include legislation, product changes, management changes, strikes, unionization, marketing agreements, and loss of important customers. Reporting for Diversified (Conglomerate) Companies Objective•3 Discuss the disclosure requirements for major business segments. In certain business climates, companies have a tendency to diversify their operations. Take the case of conglomerate General Electric (GE), whose products include locomotives and jet engines, credit card services, and water purification 8 The effects from natural disasters, like hurricanes Katrina and Rita, which occurred after the year-end for companies with August fiscal years, require disclosure in order to keep the statements from being misleading. Some companies may have to consider whether these disasters affect their ability to continue as going concerns. Accounting Trends and Techniques— 2007 listed the following types of subsequent events and their frequency of occurrence among the 600 companies surveyed: business combinations pending or effected, 94; debt incurred, reduced or refinanced, 63; discontinued operations or asset disposals, 60; litigation, 42; restructuring/bankruptcy, 28; capital stock issued or purchased, 27; stock splits or dividends, 18; and employee benefits, 12. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  14. 14. Disclosure Issues · 1325 systems. Its NBC Universal subsidiary owns NBC TV, Vivendi Universal Entertainment, and Universal Pictures. When businesses are so diversified, investors and investment analysts want more information about the details behind conglomerate financial statements. Particularly, they want income statement, balance sheet, and cash flow information on the individual segments that compose the total income figure. Illustration 24-6 shows segmented (disaggregated) financial information of an office equipment and auto parts company. ILLUSTRATION 24-6 Segmented Income Statement OFFICE EQUIPMENT AND AUTO PARTS COMPANY INCOME STATEMENT DATA (IN MILLIONS) Consolidated Office Equipment Auto Parts Net sales $78.8 $18.0 $60.8 Manufacturing costs Inventories, beginning Materials and services Wages Inventories, ending 12.3 38.9 12.9 (13.3) 4.0 10.8 3.8 (3.9) 8.3 28.1 9.1 (9.4) Selling and administrative expenses 50.8 12.1 14.7 1.6 36.1 10.5 62.9 16.3 46.6 15.9 (9.3) 1.7 (1.0) 14.2 (8.3) $ 6.6 $ 0.7 $ 5.9 Total operating expenses Income before taxes Income taxes Net income Much information is hidden in the aggregated totals. If the analyst has only the consolidated figures, he/she cannot tell the extent to which the differing product lines contribute to the company’s profitability, risk, and growth potential. For example, in Illustration 24-6, the office equipment segment looks like a risky venture. Segmented reporting would provide useful information about the two business segments and would be useful for making an informed investment decision regarding the whole company. In addition to the example of Coach, Inc. in the opening story, a classic situation that demonstrates the need for segmented data involved Caterpillar, Inc. The SEC cited Caterpillar because it failed to tell investors that nearly a quarter of its income in one year came from a Brazilian unit and was nonrecurring in nature. The company knew that different economic policies in the next year would probably greatly affect earnings of the Brazilian unit. But Caterpillar presented its financial results on a consolidated basis, not disclosing the Brazilian operations. The SEC found that Caterpillar’s failure to include information about Brazil left investors with an incomplete picture of the company’s financial results and denied investors the opportunity to see the company “through the eyes of management.” Companies have always been somewhat hesitant to disclose segmented data for various reasons: 1. Without a thorough knowledge of the business and an understanding of such important factors as the competitive environment and capital investment requirements, the investor may find the segmented information meaningless or may even draw improper conclusions about the reported earnings of the segments. 2. Additional disclosure may be helpful to competitors, labor unions, suppliers, and certain government regulatory agencies, and thus harm the reporting company. 3. Additional disclosure may discourage management from taking intelligent business risks because segments reporting losses or unsatisfactory earnings may cause stockholder dissatisfaction with management. 4. The wide variation among companies in the choice of segments, cost allocation, and other accounting problems limits the usefulness of segmented information. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  15. 15. 1326 · Chapter 24 Full Disclosure in Financial Reporting 5. The investor is investing in the company as a whole and not in the particular segments, and it should not matter how any single segment is performing if the overall performance is satisfactory. 6. Certain technical problems, such as classification of segments and allocation of segment revenues and costs (especially “common costs”), are formidable. On the other hand, the advocates of segmented disclosures offer these reasons in support of the practice: 1. Investors need segmented information to make an intelligent investment decision regarding a diversified company. (a) Sales and earnings of individual segments enable investors to evaluate the differences between segments in growth rate, risk, and profitability, and to forecast consolidated profits. (b) Segmented reports help investors evaluate the company’s investment worth by disclosing the nature of a company’s businesses and the relative size of the components. 2. The absence of segmented reporting by a diversified company may put its unsegmented, single product-line competitors at a competitive disadvantage because the conglomerate may obscure information that its competitors must disclose. The advocates of segmented disclosures appear to have a much stronger case. Many users indicate that segmented data are the most useful financial information provided, aside from the basic financial statements. As a result, the FASB has issued extensive reporting guidelines in this area. Objective of Reporting Segmented Information The objective of reporting segmented financial data is to provide information about the different types of business activities in which an enterprise engages and the different economic environments in which it operates. Meeting this objective will help users of financial statements do the following. (a) Better understand the enterprise’s performance. (b) Better assess its prospects for future net cash flows. (c) Make more informed judgments about the enterprise as a whole. Basic Principles Financial statements can be disaggregated in several ways. For example, they can be disaggregated by products or services, by geography, by legal entity, or by type of customer. However, it is not feasible to provide all of that information in every set of financial statements. GAAP requires that general-purpose financial statements include selected information on a single basis of segmentation. Thus, a company can meet the segmented reporting objective by providing financial statements segmented based on how the company’s operations are managed. The method chosen is referred to as the management approach. [3] The management approach reflects how management segments the company for making operating decisions. The segments are evident from the components of the company’s organization structure. These components are called operating segments. Identifying Operating Segments An operating segment is a component of an enterprise: (a) That engages in business activities from which it earns revenues and incurs expenses. (b) Whose operating results are regularly reviewed by the company’s chief operating decision maker to assess segment performance and allocate resources to the segment. (c) For which discrete financial information is available that is generated by or based on the internal financial reporting system. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  16. 16. Disclosure Issues · 1327 Companies may aggregate information about two or more operating segments only if the segments have the same basic characteristics in each of the following areas. (a) (b) (c) (d) (e) The nature of the products and services provided. The nature of the production process. The type or class of customer. The methods of product or service distribution. If applicable, the nature of the regulatory environment. After the company decides on the possible segments for disclosure, it makes a quantitative materiality test. This test determines whether the segment is significant enough to warrant actual disclosure. An operating segment is deemed significant, and therefore a reportable segment, if it satisfies one or more of the following quantitative thresholds. 1. Its revenue (including both sales to external customers and intersegment sales or transfers) is 10 percent or more of the combined revenue of all the company’s operating segments. 2. The absolute amount of its profit or loss is 10 percent or more of the greater, in absolute amount, of (a) the combined operating profit of all operating segments that did not incur a loss, or (b) the combined loss of all operating segments that did report a loss. 3. Its identifiable assets are 10 percent or more of the combined assets of all operating segments. In applying these tests, the company must consider two additional factors. First, segment data must explain a significant portion of the company’s business. Specifically, the segmented results must equal or exceed 75 percent of the combined sales to unaffiliated customers for the entire company. This test prevents a company from providing limited information on only a few segments and lumping all the rest into one category. Second, the profession recognizes that reporting too many segments may overwhelm users with detailed information. The FASB decided that 10 is a reasonable upper limit for the number of segments that a company must disclose. To illustrate these requirements, assume a company has identified six possible reporting segments, as shown in Illustration 24-7 (000s omitted). Segments Total Revenue (Unaffiliated) Operating Profit (Loss) Identifiable Assets A B C D E F $ 100 50 700 300 900 100 $10 2 40 20 18 (5) $ 60 30 390 160 280 50 $2,150 $85 ILLUSTRATION 24-7 Data for Different Possible Reporting Segments $970 The company would apply the respective tests as follows: Revenue test: 10% ϫ $2,150 ϭ $215; C, D, and E meet this test. Operating profit (loss) test: 10% ϫ $90 ϭ $9 (note that the $5 loss is ignored, because the test is based on non-loss segments); A, C, D, and E meet this test. Identifiable assets tests: 10% ϫ $970 ϭ $97; C, D, and E meet this test. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  17. 17. 1328 · Chapter 24 Full Disclosure in Financial Reporting Underlying Concepts The AICPA Special Committee on Financial Reporting notes that multisegment companies operate diverse businesses that are subject to different opportunities and risks. Segment information provides additional insight about the opportunities and risks of investments and sharpens predictions. Because of its predictive value, providing segment information is of the highest priority. The reporting segments are therefore A, C, D, and E, assuming that these four segments have enough sales to meet the 75 percent of combined sales test. The 75 percent test is computed as follows. 75% of combined sales test: 75% ϫ $2,150 ϭ $1,612.50. The sales of A, C, D, and E total $2,000 ($100 ϩ $700 ϩ $300 ϩ $900); therefore, the 75 percent test is met. Measurement Principles The accounting principles that companies use for segment disclosure need not be the same as the principles they use to prepare the consolidated statements. This flexibility may at first appear inconsistent. But, preparing segment information in accordance with generally accepted accounting principles would be difficult because some principles are not expected to apply at a segment level. Examples are accounting for the cost of company-wide employee benefit plans, accounting for income taxes in a company that files a consolidated tax return, and accounting for inventory on a LIFO basis if the pool includes items in more than one segment. The FASB does not require allocations of joint, common, or company-wide costs solely for external reporting purposes. Common costs are those incurred for the benefit of more than one segment and whose interrelated nature prevents a completely objective division of costs among segments. For example, the company president’s salary is difficult to allocate to various segments. Allocations of common costs are inherently arbitrary and may not be meaningful. There is a presumption that if companies allocate common costs to segments, these allocations are either directly attributable or reasonably allocable. Segmented Information Reported The FASB requires that an enterprise report the following. 1. General information about its operating segments. This includes factors that management considers most significant in determining the company’s operating segments, and the types of products and services from which each operating segment derives its revenues. 2. Segment profit and loss and related information. Specifically, companies must report the following information about each operating segment if the amounts are included in determining segment profit or loss. (a) Revenues from transactions with external customers. (b) Revenues from transactions with other operating segments of the same enterprise. (c) Interest revenue. (d) Interest expense. (e) Depreciation, depletion, and amortization expense. (f) Unusual items. (g) Equity in the net income of investees accounted for by the equity method. (h) Income tax expense or benefit. (i) Extraordinary items. (j) Significant noncash items other than depreciation, depletion, and amortization expense. 3. Segment assets. A company must report each operating segment’s total assets. 4. Reconciliations. A company must provide a reconciliation of the total of the segments’ revenues to total revenues, a reconciliation of the total of the operating segments’ profits and losses to its income before income taxes, and a reconciliation of the total of the operating segments’ assets to total assets. 5. Information about products and services and geographic areas. For each operating segment not based on geography, the company must report (unless it is impracticable): (1) revenues from external customers, (2) long-lived assets, and (3) expenditures during the period for long-lived assets. This information, if material, must be reported (a) in the enterprise’s country of domicile and (b) in each other country. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  18. 18. Disclosure Issues · 1329 6. Major customers. If 10 percent or more of company revenue is derived from a single customer, the company must disclose the total amount of revenue from each such customer by segment. Illustration of Disaggregated Information Illustration 24-8 shows the segment disclosure for Johnson & Johnson. ILLUSTRATION 24-8 Segment Disclosure Johnson & Johnson (Notes excluded) Segments of Business and Geographic Areas Sales to Customers (Dollars in Millions) 2007 Total 2006 2005 $ 6,408 8,085 Consumer—United States International $ 4,573 5,201 $ 4,405 4,691 14,493 14,478 7,844 23,267 22,322 10,433 11,303 Total 9,096 15,092 8,175 24,866 Total Medical Devices and Diagnostics—United States International 9,774 15,603 9,263 Pharmaceutical—United States International 10,110 10,173 9,494 9,602 21,736 20,283 19,096 $61,095 Worldwide total $53,324 $50,514 Operating Profit (Dollars in Millions) Consumer Pharmaceutical Medical Devices and Diagnostics Total Less: (Income)/Expenses not allocated to segments General corporate Worldwide total Identifiable Assets 2007 2006 2005 2007 2006 2005 $ 2,277 6,540 4,846 $ 1,374 6,894 6,126 $ 1,592 6,365 5,240 $26,550 19,780 19,978 $25,380 18,799 18,601 $ 6,275 16,091 16,540 13,663 380 14,394 (193) 13,197 81 66,308 62,780 38,906 14,646 7,776 19,958 $13,283 $14,587 $13,116 $80,954 $70,556 $58,864 Additions to Property, Plant & Equipment (Dollars in Millions) Consumer Pharmaceutical Medical Devices and Diagnostics Segments total General corporate Worldwide total Depreciation and Amortization 2007 2006 2005 2007 2006 2005 $ 504 1,137 919 $ 344 1,246 823 $ 321 1,388 785 $ 472 1,033 1,080 $ 255 929 861 $ 232 918 821 2,560 382 2,413 253 2,494 138 2,585 192 2,045 132 1,971 122 $2,942 $2,666 $2,632 $2,777 $2,177 $2,093 Sales to Customers (Dollars in Millions) United States Europe Western Hemisphere excluding U.S. Asia-Pacific, Africa Segments total General corporate Other non long-lived assets Worldwide total Long-Lived Assets 2007 2006 2005 2007 2006 2005 $32,444 15,644 4,681 8,326 $29,775 12,786 3,542 7,221 $28,377 12,187 3,087 6,863 $21,685 15,578 3,722 1,261 $22,432 14,443 3,108 1,206 $15,355 5,646 957 596 61,095 53,324 50,514 42,246 702 38,006 41,189 543 28,824 22,554 451 35,859 $61,095 $53,324 $50,514 $80,954 $70,556 $58,864 PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  19. 19. 1330 · Chapter 24 Full Disclosure in Financial Reporting Interim Reports Another source of information for the investor is interim reports. As noted earlier, interim reports cover periods of less than one year. The stock exchanges, the SEC, and the accounting profession have an active interest in the presentation of interim information. The SEC mandates that certain companies file a Form 10-Q, in which a company discloses quarterly data similar to that disclosed in the annual report. It also requires those companies to disclose selected quarterly information in notes to the annual financial statements. Illustration 24-9 presents the selected quarterly disclosure of Tootsie Roll Industries, Inc. In addition to Form 10-Q, GAAP narrows the reporting alternatives related to interim reports. [4] Objective•4 Describe the accounting problems associated with interim reporting. ILLUSTRATION 24-9 Disclosure of Selected Quarterly Data Tootsie Roll Industries, Inc. For the Year Ended December 31, 2007 (Thousands of dollars except per share data) Second Third Fourth First Net product sales Gross product margin Net earnings Net earnings per share $92,914 33,178 9,811 .18 $101,901 34,425 10,226 .19 $182,917 60,659 23,432 .43 Stock Prices 2007 High 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr Total $492,742 165,047 51,625 .94 Dividends 2007 $115,010 36,785 8,156 .15 Low $32.69 $30.50 $30.85 $27.44 $28.19 $27.65 $25.03 $23.55 $.08 $.08 $.08 $.08 Because of the short-term nature of the information in these reports, there is considerable controversy as to the general approach companies should employ. One group, which favors the discrete approach, believes that companies should treat each interim period as a separate accounting period. Using that treatment, companies would follow the principles for deferrals and accruals used for annual reports. In this view, companies should report accounting transactions as they occur, and expense recognition should not change with the period of time covered. Another group, which favors the integral approach, believes that the interim report is an integral part of the annual report and that deferrals and accruals should take into consideration what will happen for the entire year. In this approach, companies should assign estimated expenses to parts of a year on the basis of sales volume or some other activity base. At present, many companies follow the discrete approach for certain types of expenses and the integral approach for others, because the standards currently employed in practice are vague and lead to differing interpretations. Underlying Concepts For information to be relevant, it must be available to decision makers before it loses its capacity to influence their decisions (timeliness). Interim reporting is an excellent example of this concept. Interim Reporting Requirements Generally, companies should use the same accounting principles for interim reports and for annual reports. They should recognize revenues in interim periods on the same basis as they are for annual periods. For example, if Cedars Corp. uses the installmentsales method as the basis for recognizing revenue on an annual basis, then it should PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  20. 20. Disclosure Issues · 1331 use the installment basis for interim reports as well. Also, Cedars should treat costs directly associated with revenues (product costs, such as materials, labor and related fringe benefits, and manufacturing overhead) in the same manner for interim reports as for annual reports. Companies should use the same inventory pricing methods (FIFO, LIFO, etc.) for interim reports and for annual reports. However, the following exceptions are appropriate at interim reporting periods. 1. Companies may use the gross profit method for interim inventory pricing. But they must disclose the method and adjustments to reconcile with annual inventory. 2. When a company liquidates LIFO inventories at an interim date and expects to replace them by year-end, cost of goods sold should include the expected cost of replacing the liquidated LIFO base, rather than give effect to the interim liquidation. 3. Companies should not defer inventory market declines beyond the interim period unless they are temporary and no loss is expected for the fiscal year. 4. Companies ordinarily should defer planned variances under a standard cost system; such variances are expected to be absorbed by year-end. Companies often charge to the interim period, as incurred, costs and expenses other than product costs (often referred to as period costs). But companies may allocate these costs among interim periods on the basis of an estimate of time expired, benefit received, or activity associated with the periods. Companies display considerable latitude in accounting for these costs in interim periods, and many believe more definitive guidelines are needed. Regarding disclosure, companies should report the following interim data at a minimum. 1. Sales or gross revenues, provision for income taxes, extraordinary items, and net income. 2. Basic and diluted earnings per share where appropriate. 3. Seasonal revenue, cost, or expenses. 4. Significant changes in estimates or provisions for income taxes. 5. Disposal of a component of a business and extraordinary, unusual, or infrequently occurring items. 6. Contingent items. 7. Changes in accounting principles or estimates. 8. Significant changes in financial position. The FASB encourages, but does not require, companies to publish an interim balance sheet and statement of cash flows. If a company does not present this information, it should disclose significant changes in such items as liquid assets, net working capital, long-term liabilities, and stockholders’ equity. Unique Problems of Interim Reporting GAAP reflects a preference for the integral approach. However, within this broad guideline, a number of unique reporting problems develop related to the following items. Advertising and Similar Costs. The general guidelines are that companies should defer in an interim period costs such as advertising if the benefits extend beyond that period; otherwise the company should expense those costs as incurred. But such a determination is difficult, and even if the company defers the costs, how should it allocate them between quarters? Because of the vague guidelines in this area, accounting for advertising varies widely. At one time, some companies in the food industry, such as RJR Nabisco and PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  21. 21. 1332 · Chapter 24 Full Disclosure in Financial Reporting Pillsbury, charged advertising costs as a percentage of sales and adjusted to actual at year-end, whereas General Foods and Kellogg expensed these costs as incurred. The same type of problem relates to such items as Social Security taxes, research and development costs, and major repairs. For example, should the company expense Social Security costs (payroll taxes) on highly paid personnel early in the year, or allocate and spread them to subsequent quarters? Should a major repair that occurs later in the year be anticipated and allocated proportionately to earlier periods? Expenses Subject to Year-End Adjustment. Companies often do not know with a great deal of certainty amounts of bad debts, executive bonuses, pension costs, and inventory shrinkage until year-end. They should estimate these costs and allocate them to interim periods as best they can. Companies use a variety of allocation techniques to accomplish this objective. Income Taxes. Not every dollar of corporate taxable income is taxed at the same rate; the tax rate is progressive. This aspect of business income taxes poses a problem in preparing interim financial statements. Should the company use the annualized approach, which is to annualize income to date and accrue the proportionate income tax for the period to date? Or should it follow the marginal principle approach, which is to apply the lower rate of tax to the first amount of income earned? At one time, companies generally followed the latter approach and accrued the tax applicable to each additional dollar of income. The profession now, however, uses the annualized approach. This requires that “at the end of each interim period the company should make its best estimate of the effective tax rate expected to be applicable for the full fiscal year. The rate so determined should be used in providing for income taxes on income for the quarter.” [5]9 Because businesses did not uniformly apply this guideline in accounting for similar situations, the FASB issued authoritative guidance. GAAP now requires companies, when computing the year-to-date tax, to apply the estimated annual effective tax rate to the year-to-date “ordinary” income at the end of each interim period. Further, the interim period tax related to “ordinary” income shall be the difference between the amount so computed and the amounts reported for previous interim periods of the fiscal period. [6]10 Extraordinary Items. Extraordinary items consist of unusual and nonrecurring material gains and losses. In the past, companies handled them in interim reports in one of three ways: (1) absorbed them entirely in the quarter in which they occurred; (2) prorated them over four quarters; or (3) disclosed them only by note. The required approach now is to charge or credit the loss or gain in the quarter in which it occurs, instead of attempting some arbitrary multiple-period allocation. This approach is consistent with the way in which companies must handle extraordinary items on an annual basis. No attempt is made to prorate the extraordinary items over several years. Some favor the omission of extraordinary items from the quarterly net income. They believe that inclusion of extraordinary items that may be large in proportion to interim results distorts the predictive value of interim reports. Many, however, consider such an omission inappropriate because it deviates from actual results. Earnings per Share. Interim reporting of earnings per share has all the problems inherent in computing and presenting annual earnings per share, and then some. If a company issues shares in the third period, EPS for the first two periods will not reflect year-end 9 The estimated annual effective tax rate should reflect anticipated tax credits, foreign tax rates, percentage depletion, capital gains rates, and other available tax-planning alternatives. 10 “Ordinary” income (or loss) refers to “income (or loss) from continuing operations before income taxes (or benefits)” excluding extraordinary items and discontinued operations. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  22. 22. Disclosure Issues · 1333 EPS. If an extraordinary item is present in one period and the company sells new equity shares in another period, the EPS figure for the extraordinary item will change for the year. On an annual basis only one EPS figure can be associated with an extraordinary item and that figure does not change; the interim figure is subject to change. For purposes of computing earnings per share and making the required disclosure determinations, each interim period should stand alone. That is, all applicable tests should be made for that single period. Seasonality. Seasonality occurs when most of a company’s sales occur in one short period of the year while certain costs are fairly evenly spread throughout the year. For example, the natural gas industry has its heavy sales in the winter months. In contrast, the beverage industry has its heavy sales in the summer months. The problem of seasonality is related to the expense recognition principle in accounting. Generally, expenses are associated with the revenues they create. In a seasonal business, wide fluctuations in profits occur because off-season sales do not absorb the company’s fixed costs (for example, manufacturing, selling, and administrative costs that tend to remain fairly constant regardless of sales or production). To illustrate why seasonality is a problem, assume the following information. Selling price per unit Annual sales for the period (projected and actual) 100,000 units @ $1 Manufacturing costs Variable Fixed Nonmanufacturing costs Variable Fixed ILLUSTRATION 24-10 Data for Seasonality Example $1 $100,000 10¢ per unit 20¢ per unit or $20,000 for the year 10¢ per unit 30¢ per unit or $30,000 for the year Sales for four quarters and the year (projected and actual) were: ILLUSTRATION 24-11 Sales Data for Seasonality Example Percent of Sales 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter $ 20,000 5,000 10,000 65,000 20% 5 10 65 Total for the year $100,000 100% Under the present accounting framework, the income statements for the quarters might be as shown in Illustration 24-12. 1st Qtr Nonmanufacturing costs Variable Fixedb Net income 3rd Qtr 4th Qtr Year $20,000 $ 5,000 $10,000 $65,000 $100,000 (2,000) (4,000) (500) (1,000) (1,000) (2,000) (6,500) (13,000) (10,000) (20,000) 14,000 Sales Manufacturing costs Variable Fixeda 2nd Qtr 3,500 7,000 45,500 70,000 (2,000) (7,500) (500) (7,500) (1,000) (7,500) (6,500) (7,500) (10,000) (30,000) $ 4,500 $(4,500) $ (1,500) $31,500 ILLUSTRATION 24-12 Interim Net Income for Seasonal Business— Discrete Approach $ 30,000 a The fixed manufacturing costs are inventoried, so that equal amounts of fixed costs do not appear during each quarter. The fixed nonmanufacturing costs are not inventoried, so equal amounts of fixed costs appear during each quarter. b PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  23. 23. 1334 · Chapter 24 Full Disclosure in Financial Reporting An investor who uses the first quarter’s results might be misled. If the first quarter’s earnings are $4,500, should this figure be multiplied by four to predict annual earnings of $18,000? Or, if first-quarter sales of $20,000 are 20 percent of the predicted sales for the year, would the net income for the year be $22,500 ($4,500 ϫ 5)? Both figures are obviously wrong, and after the second quarter’s results occur, the investor may become even more confused. The problem with the conventional approach is that the fixed nonmanufacturing costs are not charged in proportion to sales. Some enterprises have adopted a way of avoiding this problem by making all fixed nonmanufacturing costs follow the sales pattern, as shown in Illustration 24-13. ILLUSTRATION 24-13 Interim Net Income for Seasonal Business— Integral Approach 1st Qtr Nonmanufacturing costs Variable Fixed Net income 2nd Qtr 3rd Qtr 4th Qtr Year $20,000 $ 5,000 $10,000 $65,000 $100,000 (2,000) (4,000) (500) (1,000) (1,000) (2,000) (6,500) (13,000) (10,000) (20,000) 14,000 Sales Manufacturing costs Variable Fixed 3,500 7,000 45,500 70,000 (2,000) (6,000) (500) (1,500) (1,000) (3,000) (6,500) (19,500) (10,000) (30,000) $ 6,000 $ 1,500 $ 3,000 $19,500 $ 30,000 This approach solves some of the problems of interim reporting: Sales in the first quarter are 20 percent of total sales for the year, and net income in the first quarter is 20 percent of total income. In this case, as in the previous example, the investor cannot rely on multiplying any given quarter by four, but can use comparative data or rely on some estimate of sales in relation to income for a given period. The greater the degree of seasonality experienced by a company, the greater the possibility of distortion. Because there are no definitive guidelines for handling such items as the fixed nonmanufacturing costs, variability in income can be substantial. To alleviate this problem, the profession recommends that companies subject to material seasonal variations disclose the seasonal nature of their business and consider supplementing their interim reports with information for 12-month I NTERNATIONAL periods ended at the interim date for the current and preceding years. I NSIGHT The two illustrations highlight the difference between the discrete and inteiGAAP requires that interim gral approaches. Illustration 24-12 represents the discrete approach, in which the financial statements use the discrete fixed nonmanufacturing expenses are expensed as incurred. Illustration 24-13 method, except for tax expenses. shows the integral approach, in which expenses are charged to expense on the basis of some measure of activity. Underlying Concepts The AICPA Special Committee on Financial Reporting indicates that users would benefit from separate fourth-quarter reporting, including management’s analysis of fourthquarter activities and events. Also, the Committee recommended quarterly segment reporting, which companies now provide. Continuing Controversy. The profession has developed some rules for interim reporting, but much still has to be done. As yet, it is unclear whether the discrete or the integral method, or some combination of the two, will be settled on. Discussion also persists about the independent auditor’s involvement in interim reports. Many auditors are reluctant to express an opinion on interim financial information, arguing that the data are too tentative and subjective. On the other hand, more people are advocating some examination of interim reports. As a compromise, the SEC currently requires that auditors perform a review of interim financial information. Such a review, which is much more PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  24. 24. Auditor’s and Management’s Reports · 1335 limited in its procedures than the annual audit, provides some assurance that the interim information appears to be in accord with GAAP.11 Analysts and investors want financial information as soon as possible, before it’s old news. We may not be far from a continuous database system in which corporate financial records can be accessed via the Internet. Investors might be able to access a company’s financial records whenever they wish and put the information in the format they need. Thus, they could learn about sales slippage, cost increases, or earnings changes as they happen, rather than waiting until after the quarter has ended.12 A steady stream of information from the company to the investor could be very positive because it might alleviate management’s continual concern with short-run interim numbers. Today many contend that U.S. management is too oriented to the shortterm. The truth of this statement is echoed by the words of the president of a large company who decided to retire early: “I wanted to look forward to a year made up of four seasons rather than four quarters.” “I WANT IT FASTER” The SEC has decided that timeliness of information is of extreme importance. First, the SEC has said that large public companies will have only 60 days to complete their annual reports, down from 90 days. Quarterly reports must be done within 40 days of the close of the quarter, instead of 45. In addition, corporate executives and shareholders with more than 10 percent of a company’s outstanding stock now have two days to disclose their sale or purchase of stock. Also, in a bid to increase Internet disclosure, the SEC encourages companies to post current, quarterly, and annual reports on their websites—or explain why they don’t. The Internet postings would have to be made by the day the company submits the information to the SEC, rather than within 24 hours as current rules allow. What do the numbers mean? AUDITOR’S AND MANAGEMENT’S REPORTS Auditor’s Report Another important source of information, which is often overlooked, is the auditor’s report. An auditor is an accounting professional who conducts an independent examination of a company’s accounting data. If satisfied that the financial statements present the financial position, results of operations, and cash flows fairly in accordance with generally accepted accounting principles, the auditor expresses an unqualified opinion. An example is shown in Illustration 24-14 (on page 1336).13 Objective•5 Identify the major disclosures in the auditor’s report. 11 “Interim Financial Information,”Statement on Auditing Standards No. 101 (New York, AICPA, 2002). 12 A step in this direction is the SEC’s mandate for companies to file their financial statements electronically with the SEC. The system, called EDGAR (electronic data gathering and retrieval) provides interested parties with computer access to financial information such as periodic filings, corporate prospectuses, and proxy materials. 13 This auditor’s report is in exact conformance with the specifications contained in “Reports on Audited Financial Statements,” Statement on Auditing Standards No. 58 (New York: AICPA, 1988). The last paragraph refers to the assessment of the company’s internal controls, as required by the PCAOB. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  25. 25. 1336 · Chapter 24 Full Disclosure in Financial Reporting ILLUSTRATION 24-14 Auditor’s Report Best Buy Co., Inc. Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of Best Buy Co., Inc. We have audited the accompanying consolidated balance sheets of Best Buy Co., Inc. and subsidiaries (the “Company”) as of March 1, 2008 and March 3, 2007, and the related consolidated statements of earnings, shareholders’ equity, and cash flows for each of the three years in the period ended March 1, 2008, March 3, 2007 and February 25, 2006. Our audits also included the financial statement schedule listed in the index at Item 15(a). These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Best Buy Co., Inc. and subsidiaries as of March 1, 2008 and March 3, 2007, and the results of their operations and their cash flows for each of the three years in the period ended March 1, 2008, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. As discussed in Note 1 to the consolidated financial statements, effective March 4, 2007, Best Buy Co., Inc. and subsidiaries changed their method of accounting for uncertain tax benefits upon adoption of Financial Accounting Standards Board Interpretation No. 48. Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of March 1, 2008, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated April 25, 2008 expressed an unqualified opinion on the Company’s internal control over financial reporting. Minneapolis, Minnesota April 25, 2008 In preparing the report, the auditor follows these reporting standards. 1. The report states whether the financial statements are in accordance with generally accepted accounting principles. 2. The report identifies those circumstances in which the company has not consistently observed such principles in the current period in relation to the preceding period. 3. Users are to regard the informative disclosures in the financial statements as reasonably adequate unless the report states otherwise. 4. The report contains either an expression of opinion regarding the financial statements taken as a whole or an assertion to the effect that an opinion cannot be expressed. When the auditor cannot express an overall opinion, the report should state the reasons. In all cases where an auditor’s name is associated with financial statements, the report should contain a clear-cut indication of the character of the auditor’s examination, if any, and the degree of responsibility being taken. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark
  26. 26. Auditor’s and Management’s Reports · 1337 In most cases, the auditor issues a standard unqualified or clean opinion. That is, the auditor expresses the opinion that the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the entity in conformity with generally accepted accounting principles. Certain circumstances, although they do not affect the auditor’s unqualified opinion, may require the auditor to add an explanatory paragraph to the audit report. Some of the more important circumstances are as follows. 1. Going Concern. The auditor must evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, taking into consideration all available information about the future. (The future is at least, but not limited to, 12 months from the end of the reporting period.) If substantial doubt exists about the company continuing as a going concern, the auditor adds to the report an explanatory note describing the potential problem. [7] 2. Lack of Consistency. If a company has changed accounting principles or the method of their application in a way that has a material effect on the comparability of its financial statements, the auditor should refer to the change in an explanatory paragraph of the report. Such an explanatory paragraph should identify the nature of the change and refer readers to the note in the financial statements that discusses the change in detail. The auditor’s concurrence with a change is implicit unless the auditor takes exception to the change in expressing an opinion as to fair presentation in conformity with generally accepted accounting principles. 3. Emphasis of a Matter. The auditor may wish to emphasize a matter regarding the financial statements, but nevertheless intends to express an unqualified opinion. For example, the auditor may wish to emphasize that the entity is a component of a larger business enterprise or that it has had significant transactions with related parties. The auditor presents such explanatory information in a separate paragraph of the report. In some situations, however, the auditor is required to express (1) a qualified opinion or (2) an adverse opinion, or (3) to disclaim an opinion. A qualified opinion contains an exception to the standard opinion. Ordinarily the exception is not of sufficient magnitude to invalidate the statements as a whole; if it were, an adverse opinion would be rendered. The usual circumstances in which the auditor may deviate from the standard unqualified short-form report on financial statements are as follows. 1. The scope of the examination is limited or affected by conditions or restrictions. 2. The statements do not fairly present financial position or results of operations because of: (a) Lack of conformity with generally accepted accounting principles and standards. (b) Inadequate disclosure. If confronted with one of the situations noted above, the auditor must offer a qualified opinion. A qualified opinion states that, except for the effects of the matter to which the qualification relates, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows in conformity with generally accepted accounting principles. Illustration 24-15 (page 1338) shows an example of an auditor’s report with a qualified opinion. The auditor qualified the opinion because the company used an accounting principle at variance with generally accepted accounting principles. PDF Watermark Remover DEMO : Purchase from www.PDFWatermarkRemover.com to remove the watermark

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