External Reporting Issues

1. External Reporting Issues Chapter 12

2. Learning Objective 1 • Characterize the importance of • external financial information • to financial statement users.

3. External Financial Reporting The objective of accounting is to provide information that is useful in making investment and credit decisions, in assessing future cash flows, and identifying enterprise resources, claims to resources, and changes in them.

4. External Financial Reporting The SEC requires publicly held companies to file quarterly (10Q) and annual (10K) financial statements.

5. Importance of External Information to Shareholders Shareholders and potential investors expect safety for their investment and return on the investment.

6. Bankruptcy Danger ahead! Watch out for insolvency Beware of illiquidity Financial health Now entering unprofitable regions Net profit The Road to Bankruptcy

7. 2500 2000 Sears 1500 JCPenney 1000 Kmart 500 The Gap 0 In $Millions -500 -1000 -1500 -2000 -2500 -3000 1993 1994 1995 1996 1997 1998 1999 2000 2001 Comparison ofAnnual Earnings

8. 70 60 50 Sears 40 JCPenney Stock Price in $ Kmart 30 Gap 20 10 0 1993 1994 1995 1996 1997 1998 1999 2000 2001 Comparison ofAnnual Stock Prices

9. Trade creditors Commercial lending institutions Importance of External Information to Creditors Short-term creditors Long-term creditors

10. Importance of External Information to Regulators – Internal Revenue Service – Securities and Exchange Commission – State taxation agencies – Utility rate-setting agencies Regulators depend upon periodic reports from the organizations they oversee as evidence of compliance with rules and regulations.

11. Ethics Ethical Considerations of External Financial Reporting Good ethics is good business.

12. Learning Objective 2 • Differentiate the different • valuations used for • external financial reporting.

13. External Reporting Valuation Historical cost Net realizable value Lower of cost or market Fair value or market value Present value

14. Alternative Accounting Principles Many businesses have different reporting requirements due to the nature of their industry. Alternative accounting principles have developed because of such differences. Using one accounting method instead of another should not make a material difference in economic decision making.

15. Accounting Concepts 1. Consistency 2. Full Disclosure 3. Financial statements must be representationally faithful.

16. Learning Objective 3 • Compare and contrast the straight-line and double-declining-balance methods of depreciation and the effects • of using each on the balance sheet and income statement.

17. Time Time Depreciation

18. Depreciation The Effect of Estimates Length of the asset’s useful live Amount of residual value

19. The Effect of Estimates Elevation Sports, Inc., purchased equipment for $75,000. It is assumed that the equipment would last for five years. Its estimated residual value is $15,000. What is the depreciation expense?

20. The Effect of Estimates $75,000 – $15,000 = $60,000 $60,000 ÷ 5 = $12,000 What is the depreciation expense if its estimated residual value is $13,000. $75,000 – $13,000 = $62,000 $62,000 ÷ 5 = $13,000

21. $ Gain Book value $ Loss The Effect of Estimates Gains or losses are computed on the sale of assets.

22. Straight-Line and Accelerated Depreciation Methods The straight-line method assumes an asset is used equally in each time period of its useful life. Accelerated depreciation methods record a large amount of depreciation expense in the early years of an asset’s life.

23. Learning Objective 4 • Calculate depreciation using • the straight-line and double- • declining-balance methods.

24. Elevation Sports, Inc. Pro Forma Income Statement For the Years Ended May 31 2002 2003 2004 2005 Income before depreciation $117,300 $117,300 $117,300 $117,300 Depreciation 12,000$ 12,000$ 12,000$ 12,000 Income before taxes $105,300 $105,300 $105,300 $105,300 Income tax expense 42,120 42,120 42,120 42,120 Net income $ 63,180 $ 63,180 $ 63,180 $ 63,180 Straight-Line Depreciation

25. Straight-Line Depreciation Elevation Sports, Inc. Pro Forma Balance Sheet May 31 2002 2003 2004 2005 Cash $132,880 $208,060 $283,240 $358,420 Other current assets 61,800 61,800 61,800 61,800 Equipment 75,000 75,000 75,000 75,000 Less: Acc. depreciation (12,000) (12,000) (12,000) (12,000) Other assets 34,300 34,300 34,300 34,300 Total assets $291,980 $355,160 $418,340 $481,520 Total liabilities $128,800 $128,800 $128,800 $128,800 Common stock 100,000 100,100 100,000 100,000 Retained earnings 63,180 126,360 189,540 252,720 Total liabilities and stockholders’ equity $291,980 $355,160 $418,340 $481,520

26. Year Beginning book value Depreciation expense Ending book value 2002 $75,000 $30,000 $45,000 2003 45,000 18,000 27,000 2004 27,000 10,800 16,200 2005 16,200 1,200 15,000 2006 15,000 -0- 15,000 Double-Declining-Balance Depreciation

27. Learning Objectives 5 and 6 • Compare and contrast different • methods of accounting for • inventories and the effects • of using each on the balance sheet and income statement. Compute inventories using different methods.

28. Differences inInventory Methods First-in, first out (FIFO) Last-in, first out (LIFO) Average cost Specific identification

29. Date Transaction Units Unit cost Unit selling price 9-1 Beginning inventory 1 $ 800 9-3 Purchase 2 $1,025 9-17 Sale 1 $1,500 9-22 Purchase1 $1,100 9-26 Purchase 1 $1,200 9-29 Purchase 1 $1,450 9-30 Sale 2 $1,500 The Flow of Inventory Cost: Harwood Example

30. First-in, First-out Method (FIFO) Total purchases = $5,800 What is the cost of the units sold? Beginning inventory 1 @ $ 800 $ 800 9-3 Purchases 2 @ $1,025 2,050 Cost of units sold $2,850

31. First-in, First-out Method (FIFO) 9-29 purchase 1 @ $1,450 $1,450 9-26 purchase 1 @ $1,200 1,200 9-22 purchase1 @ $1,100 1,100 Cost of ending inventory $3,750 Beginning inventory $800 + Purchases $5,800 = Goods available for sale $6,600 $6,600 – $3,750 = Cost of goods sold $2,850

32. Last-in, First-out Method (LIFO) What is the cost of the units sold? 9-29 purchase 1 @ $1,450 $1,450 9-26 purchase 1 @ $1,200 1,200 9-22 purchase1 @ $1,100 1,100 Cost of units sold $3,750

33. Last-in, First-out Method (LIFO) What is the cost of ending inventory? Beginning inventory 1 @ $ 800 $ 800 9-3 purchase 2 @ $1,025 2,050 Cost of ending inventory $2,850

34. – Ending inventory $3,300 (3 × $1,100) = Cost of goods sold $3,300 (3 × $1,100) Average Cost Method Average cost = $6,600 ÷ 6 = $1,100/unit Cost of goods available for sale $6,600

35. September 30 FIFO LIFO Average cost Sales $4,500 $4,500 $4,500 Cost of goods sold 2,850 3,750 3,300 Gross margin $1,650 $ 750 $1,200 Operating expenses 200 200 200 Net income $1,450 $ 550 $1,000 Comparison of Methods:Income Statement

36. FIFO LIFO Average cost August 31 September 30 Cash $21,000 $22,300 $22,300 $22,300 Accounts receivable 1,500 4,500 4,500 4,500 Merchandise inventory 800 3,750 2,850 3,300 Total assets $23,300 $30,550 $29,650 $30,100 Accounts payable $ -0- $ 5,800 $ 5,800 $ 5,800 Common stock 15,000 15,000 15,000 15,000 Additional paid-in capital 8,000 8,000 8,000 8,000 Retained earnings 300 1,750 850 1,300 Total liabilities and stockholders’ equity $23,300 $30,550 $29,650 $30,100 Comparison of Methods: Balance Sheet

37. Learning Objective 7 • Evaluate disclosure • requirements for • external reporting.

38. Reporting Inventories in the Notes to Financial Statements Before IRS instituted the LIFO Conformity Rule, many firms used FIFO inventory for financial statements and LIFO inventory for tax purposes. The LIFO Conformity Rule changed this practice by requiring firms to use the same inventory method for tax purposes that they use for financial statements purposes

39. Comparison of Inventory Disclosures Family Dollar Stores, Inc. and Subsidiaries Notes to Consolidated Financial Statements Years Ended September 1, 2001, August 26, 2000, and August 28, 1999 1. Description of Business and Summary of Significant Accounting Policies: Merchandise inventories: Inventories are valued using retail prices less markon percentages, and approximate the lower of first-in, first-out (FIFO) cost or market

40. Target Corporation and subsidiaries notes to financial statements Inventory Inventory and the related cost of sales are accounted for by the retail inventory accounting method using the last-in, first-out (LIFO) basis and are stated at the lower of LIFO cost or market. The cumulative LIFO provision was $64 million and $57 million at year-end 2001 and 2000, respectively. Inventory (millions) 2001 2000 Target $3,348 $3,090 Mervyn’s 523 561 Marshall Field’s 348 396 Other 230 201 Total Inventory $4,449 $4,248 Comparison of Inventory Disclosures

41. (in millions) Family Dollar Target (LIFO) Target (FIFO) Sales $3,665 $39,176 $39,176 Cost of sales 2,439 27,246 27,239 Gross margin $1,226 $11,930 $11,937 Profit before taxes $ 298 $ 2,216 $ 2,223 Ending inventory $ 722 $ 4,449 $ 4,513 Implications of LIFOand Ratio Comparisons

42. Implications of LIFOand Ratio Comparisons (in millions) Family Dollar Target (LIFO) Target (FIFO) Gross margin $1,226$11,930$11,937 ÷ Sales $3,665 $39,176 $39,176 = Gross profit % 33.45% 30.45% 30.47% Profit before taxes $ 298 $ 2,216 $ 2,223 ÷ Sales $3,665$39,176$39,176 = Profit margin before taxes 8.13% 5.66% 5.67%

43. Implications of LIFOand Ratio Comparisons (in millions) Family Dollar Target (LIFO) Target (FIFO) Cost of sales $2,439$27,246$27,239 ÷ Inventory $ 722 $ 4,449 $ 4,513 = Inventory turnover 3.40 6.12 6.03 Days inventory 107.4 59.6 60.5 (365 ÷ Inventory turnover)

44. End of Chapter 12