Financial Reporting and Analysis

Title
Contents
1 The Economic and Institutional Setting for Financial Reporting
	WorldCom in May 2002
	Why Financial Statements Are Important
	Untangling the Web at WorldCom
	Economics of Accounting Information
	Demand for Financial Statements
	Disclosure Incentives and the Supply of Financial Information
	A Closer Look at Professional Analysts
	Analysts’ Decisions
	Analysts’ Information Needs
	The Rules of the Financial Reporting Game
	Generally Accepted Accounting Principles
	Who Determines the Rules?
	FASB Accounting Standards Codification TM
	The Politics of Accounting Standards
	Adversarial Nature of Financial Reporting
	Aggressive Financial Reporting: A Case Study
	An International Perspective
	International Financial Reporting
	International Accounting Standards Board (IASB)
	The March toward Convergence
	Challenges Confronting the Analyst
	APPENDIX: GAAP in the United States
	Early Developments
	Emergence of GAAP
	Current Institutional Structure in the United States
2 Accrual Accounting and Income Determination
	Example: Cash versus Accrual Income Measurement
	Measurement of Profit Performance: Revenues and Expenses
	Criteria for Revenue Recognition
	Matching Expenses with Revenues
	Income Statement Format and Classification
	Special or Unusual Items (Item 2)
	Discontinued Operations (Item 3)
	Extraordinary Items (Item 4)
	Frequency and Magnitude of Various Categories of Transitory Income Statement Items
	Reporting Accounting Changes
	Earnings per Share
	Comprehensive Income and Other Comprehensive Income
	Global Vantage Point
	Sections, Categories, and Subcategories
	APPENDIX: Review of Accounting Procedures and T-Account Analysis
	Understanding Debits and Credits
	Adjusting Entries
	Closing Entries
3 Additional Topics in Income Determination
	Revenue Recognition Prior to Sale
	Percentage-of-Completion Method
	Completed-Contract Method
	Revenue Recognition on Commodities
	Revenue Recognition Subsequent to Sale
	Installment Sales Method
	Cost Recovery Method
	Revenue Recognition for Specialized Sales Transactions
	Franchise Sales 146 xvii
	Sales with Right of Return
	Bundled (Multiple-Element) Sales
	Earnings Management
	Popular Earnings Management Devices
	Accounting Errors, Earnings Restatements, and Prior Period Adjustments
	Global Vantage Point
	IFRS Revenue Recognition and Measurement
	Long-Term Construction Accounting
	Installment Sales
	Joint IASB/FASB Project on Revenue Recognition
4 Structure of the Balance Sheet and Statement of Cash Flows
	Classification Criteria and Measurement Conventions for Balance Sheet Accounts
	Analytical Insights: Understanding the Nature of a Firm’s Business
	International Differences in Balance Sheet Presentation
	Notes to Financial Statements
	Statement of Cash Flows
	Cash Flows versus Accrual Earnings
	Deriving Cash Flow Information
	Global Vantage Point
	Defining the Sections, Categories, and Subcategories in the Statements
5 Essentials of Financial Statement Analysis
	Basic Approaches
	Financial Statement Analysis and Accounting Quality
	A Case in Point: Getting Behind the Numbers at Whole Foods Market
	Examining Whole Foods Market’s Financial Statements
	Profitability, Competition, and Business Strategy
	Financial Ratios and Profitability Analysis
	ROA and Competitive Advantage
	Return on Common Equity and Financial Leverage
	Components of ROCE
	Global Vantage Point
	Liquidity, Solvency, and Credit Analysis
	Cash Flow Analysis
	Financial Ratios and Default Risk
	APPENDIX: Altman’s Z-Score and the Prediction of Bankruptcy
6 The Role of Financial Information in Valuation and Credit Risk Assessment
	Business Valuation
	The Discounted Free Cash Flow Approach to Valuation
	The Role of Earnings in Valuation
	The Abnormal Earnings Approach to Valuation
	Fair Value Accounting
	Global Vantage Point
	Research on Earnings and Equity Valuation
	Sources of Variation in P/E Multiples
	Earnings Surprises
	Credit Risk Assessment
	Traditional Lending Products
	Credit Analysis
	Credit-Rating Agencies
	APPENDIX A: Discounted Cash Flow and Abnormal Earnings Valuation Applications
	Valuing a Business Opportunity
	Valuing Whole Foods Market’s Shares
	APPENDIX B: Financial Statement Forecasts
	Illustration of Comprehensive Financial Statement Forecasts
7 The Role of Financial Information in Contracting
	Finalizing the BookWorm Loan
	Conflicts of Interest in Business Relationships
	Debt Covenants in Lending Agreements
	Affirmative Covenants, Negative Covenants, and Default Provisions
	Mandated Accounting Changes May Trigger Debt Covenant Violation
	Managers’ Responses to Potential Debt Covenant Violations
	Management Compensation
	How Executives Are Paid
	Proxy Statements and Executive Compensation
	Incentives Tied to Accounting Numbers
	Catering to Wall Street
	Regulatory Agencies
	Capital Requirements in the Banking Industry
	Rate Regulation in the Electric Utilities Industry
	Taxation
	Fair Value Accounting and the Financial Crisis
	The Meltdown
	The Controversy
	Analytical Insights: Incentives to “Manage” Earnings
8 Receivables
	Assessing the Net Realizable Value of Accounts Receivable
	Estimating Uncollectibles
	Assessing the Adequacy of the Allowance for Uncollectibles Account Balance
	Estimating Sales Returns and Allowances
	Analytical Insight: Do Existing Receivables Represent Real Sales?
	Imputing Interest on Trade Notes Receivable
	The Fair Value Option
	Accelerating Cash Collection: Sale of Receivables and Collateralized Borrowings
	Sale of Receivables (Factoring)
	Borrowing Using Receivables as Collateral
	Ambiguities Abound: Is It a Sale or a Borrowing?
	A Closer Look at Securitizations
	Securitization and the 2008 Financial Crisis
	Some Cautions for Statement Readers
	Troubled Debt Restructuring
	Settlement
	Continuation with Modification of Debt Terms
	Evaluating Troubled Debt Restructuring Rules
	Global Vantage Point
	Comparison of IFRS and GAAP Receivable Accounting
	Expected FASB and IASB Actions
9 Inventories
	An Overview of Inventory Accounting Issues
	Determination of Inventory Quantities
	Items Included in Inventory
	Costs Included in Inventory
	Manufacturing Costs
	Absorption Costing versus Variable Costing
	Vendor Allowances
	Cost Flow Assumptions: The Concepts
	First-In, First-Out (FIFO) Cost Flow
	Last-In, First-Out (LIFO) Cost Flow
	FIFO, LIFO, and Inventory Holding Gains
	The LIFO Reserve Disclosure
	Inflation and LIFO Reserves
	LIFO Liquidation
	Reconciliation of Changes in LIFO Reserve
	Improved Trend Analysis
	Eliminating LIFO Ratio Distortions
	Tax Implications of LIFO
	Eliminating Realized Holding Gains for FIFO Firms
	Analytical Insights: LIFO Dangers
	Empirical Evidence on Inventory Policy Choice
	Lower of Cost or Market Method
	The Contracting Origins of the Lower of Cost or Market Method
	Evaluation of the Lower of Cost or Market Rule
	Global Vantage Point
	Comparison of IFRS and GAAP Inventory Accounting
	Future Directions
	APPENDIX A: Eliminating Realized Holding Gains from FIFO Income
	APPENDIX B: Dollar-Value LIFO
	APPENDIX C: Inventory Errors
10 Long-Lived Assets
	Measurement of the Carrying Amount of Long-Lived Assets
	The Approach Used by GAAP
	Long-Lived Asset Measurement Rules Illustrated
	Financial Analysis and Fixed Asset Reporting
	Intangible Assets
	Asset Impairment
	Tangible and Amortizable Intangible Assets
	Indefinite-Lived Intangible Assets
	Case Study of Impairment Recognition and Disclosure—Fortune Brands
	Management Judgments and Impairments
	Obligations Arising from Retiring Long-Lived Assets
	Assets Held for Sale
	Depreciation
	Disposition of Long-Lived Assets
	Financial Analysis and Depreciation Differences
	Exchanges of Nonmonetary Assets
	Exchanges Recorded at Book Value
	Global Vantage Point
	Comparison of IFRS and GAAP Long-Lived Asset Accounting
	Future Directions
11 Financial Instruments as Liabilities
	Balance Sheet Presentation
	Global Vantage Point
	Debt or Equity?
	Bonds Payable
	Characteristics of Bond Cash Flows
	Bonds Issued at Par
	Bonds Issued at a Discount
	Bonds Issued at a Premium
	Graphic Look at Bonds
	Book Value versus Market Value after Issuance
	Fair Value Option
	Global Vantage Point
	Managerial Incentives and Financial Reporting for Debt
	Debt Carried at Amortized Historical Cost
	Imputed Interest on Notes Payable
	Analytical Insights: Future Cash Flow Effects of Debt
	Incentives for Off-Balance-Sheet Liabilities
	Hedges
	Typical Derivative Instruments and the Benefits of Hedging
	Financial Reporting for Derivative Instruments
	Hedge Accounting
	Fair Value Hedge Accounting
	Cash Flow Hedge Accounting
	Hedge Accounting for a Forecasted Transaction
	Hedge Effectiveness
	Global Vantage Point
	Contingent Liabilities
	Measuring and Recognizing Loss Contingencies
	Recording Gain Contingencies
	Global Vantage Point
12 Financial Reporting for Leases
	Evolution of Lease Accounting
	Why Lessees Like the Operating Lease Method
	The Securities and Exchange Commission’s Initiative
	Lessee Accounting
	FASB ASC 840 Criteria for Capital Lease Treatment
	Capital Lease Treatment Illustrated
	Executory Costs
	Residual Value Guarantees
	Payments in Advance
	Financial Statement Effects of Treating a Lease as a Capital Lease versus Treating It as an Operating Lease
	Lessees’ Financial Statement Disclosures
	Lessor Accounting
	Sales-Type and Direct Financing Leases
	Lessors’ Operating Leases
	Distinction between Capital and Operating Leases
	Direct Financing Lease Treatment Illustrated
	Guaranteed versus Unguaranteed Residual Values
	Financial Statement Effects of Direct Financing versus Operating Leases
	Sales-Type Lease Treatment Illustrated
	Additional Leasing Aspects
	Sale and Leaseback
	Other Special Lease Accounting Rules
	Financial Reporting versus Tax Accounting for Leases
	Lessors’ Disclosures
	Global Vantage Point
	Comparison of IFRS and GAAP Lease Accounting
	FASB and IASB Joint Exposure Draft
	APPENDIX: Making Financial Statement Data Comparable by Adjusting for Off-Balance-Sheet Leases
13 Income Tax Reporting
	Understanding Income Tax Reporting
	Temporary and Permanent Differences between Book Income and Taxable Income
	Problems Caused by Temporary Differences
	Deferred Income Tax Accounting: Interperiod Tax Allocation
	Deferred Income Tax Assets
	Deferred Income Tax Asset Valuation Allowances
	Illustration of Footnote Disclosure for Valuation Allowances
	Classification of Deferred Tax Assets and Deferred Tax Liabilities
	Deferred Income Tax Accounting When Tax Rates Change
	Net Operating Losses: Carrybacks and Carryforwards
	Using Footnote Disclosures to Improve Financial Analysis
	Understanding Income Tax Footnote Disclosures
	Measuring and Reporting Uncertain Tax Positions
	Assessing Uncertain Tax Position Related to a Permanent Difference
	Recording Uncertain Tax Position Related to Timing of Deductibility
	Making Changes or Resolving Uncertain Tax Positions
	Assessing Disclosures on Uncertain Tax Positions
	Extracting Analytical Insights from Footnote Disclosures
	Using Deferred Tax Footnotes to Assess Earnings Quality
	Using Tax Footnotes to Improve Interfirm Comparability
	Using Income Tax Footnotes to Assess the Degree of Conservatism in Firms’ Accounting Choices
	Global Vantage Point
	Approach for Recognizing Deferred Tax Assets
	Reconciliation of Statutory and Effective Tax Rates
	Reporting Deferred Taxes on the Balance Sheet
	Disclosure of Income Tax Amounts Recognized Directly in Equity (Other Comprehensive Income)
	Uncertain Tax Positions
	IASB Exposure Draft on Income Taxes
	APPENDIX: Comprehensive Interperiod Tax Allocation Problem
	Computation of Taxable Income and Taxes Payable
	Calculation of Change in Deferred Tax Asset and Liability Accounts
	Calculation of Tax Expense
14 Pensions and Postretirement Benefits
	Rights and Obligations in Pension Contracts
	Accounting Issues Related to Defined Benefit Pension Plans
	Financial Reporting for Defined Benefit Pension Plans
	A Simple Example: A World of Complete Certainty
	The Real World: Uncertainty Introduces Gains and Losses
	Journal Entries for Changes in Funded Status
	Determinants of Pension Funding
	Case Study of Pension Recognition and Disclosure— General Electric
	Accumulated Other Comprehensive Income Disclosure and Deferred Income Taxes
	Additional Issues in Computing Expected Return
	Extraction of Additional Analytic Insights from Footnote Disclosures
	Cash Balance Plans
	Postretirement Benefits Other Than Pensions
	Analytical Insights: Assessing OPEB Liability
	Evaluation of Pension and Postretirement Benefit Financial Reporting
	Global Vantage Point
	Comparison of IFRS and GAAP Retirement Benefit Accounting
	FASB and IASB Activity
15 Financial Reporting for Owners’ Equity
	Appropriate Income Measurement
	What Constitutes the “Firm”? Entity View versus Proprietary View
	Why Companies Repurchase Their Stock
	Compliance with Contract Terms
	Legality of Corporate Dividend Distributions
	Shareholders’ Equity: Financial Statement Presentation
	Global Vantage Point
	Earnings per Share
	Simple Capital Structure
	Complex Capital Structure
	Analytical Insights
	Is Earnings per Share a Meaningful Number?
	Global Vantage Point
	Accounting for Share-Based Compensation
	Historical Perspective
	Opposition to the FASB
	The Initial Compromise— SFAS No. 123
	Stock Options Debate Rekindled
	Current GAAP Requirements
	Options Backdating Scandal
	Convertible Debt
	Background
	Financial Reporting Issues
	Analytical Insights
	Global Vantage Point
16 Intercorporate Equity Investments
	Noncontrolling (Minority) Ownership
	Minority Passive Investments: Fair Value Accounting
	Other-Than-Temporary Impairment of Investments
	Minority Active Investments: Equity Method
	Fair Value Option for Equity Method Investments
	Controlling Financial Interest (Majority Ownership)
	Acquisition Method and Preparation of Consolidated Statements (100% Acquisition)
	Adjustments to the Consolidated Balance Sheet
	Other Consolidation Adjustments—Intra-entity Transactions
	Acquisition Method with Noncontrolling Interests
	Noncontrolling Interest under the Purchase Method
	Proportionate Consolidation
	Accounting for Goodwill
	Acquisition and Purchase Methods versus Pooling-of-Interests Method
	Acquisition and Purchase Methods Complicate Financial Analysis
	Consolidation of Variable Interest Entities
	Accounting for Foreign Subsidiaries
	Foreign Currency Transactions
	Accounting for Nonfreestanding Foreign Subsidiaries
	Accounting for Self-Contained Foreign Subsidiaries
	Global Vantage Point
	Accounting for Financial Assets (Marketable Securities and Investments)
	Consolidated Financial Statements and Accounting for Business Combinations
	Accounting for Special Purpose Entities (SPEs) or Variable Interest Entities (VIEs)
	Accounting for Joint Ventures
	FASB Exposure Draft on Financial Instruments
	APPENDIX A: Accounting for Held-to-Maturity Debt Investments
	APPENDIX B: Pooling-of-Interests Accounting
	Acquisition versus Pooling Methods and Financial Analysis
17 Statement of Cash Flows
	Statement Format
	The Direct Method
	The Indirect Method
	Other Elements of the Cash Flow Statement
	Preparing the Cash Flow Statement
	Cash Flows from Operating Activities
	Cash Flows from Investing Activities
	Cash Flows from Financing Activities
	Reconciling between Statements: Some Complexities
	Discrepancies in Current Accruals
	Discrepancies Related to Property, Plant, and Equipment
	Simultaneous Noncash Financing and Investing Activities
	Analytical Insights: Ways Operating Cash Flows Can Be Distorted or Manipulated
	Changes in Working Capital Accounts
	Accounts Receivable Sale (Securitization) versus Collateralized Borrowing
	Capitalizing versus Expensing
	Software Development Costs
	Capital versus Operating Leases
	Cash Flow Impact of Stock Option Expensing
	Global Vantage Point
	Reporting of Interest Received and Paid, Dividends Received and Paid, and Tax Refunds and Payments
	Joint IASB and FASB Proposal on Statement of Cash Flows
Appendix Time Value of Money
	Future Value
	Present Value
	Present Value of an Ordinary Annuity
	Present Value of an Annuity Due
Index