Chapter 4

1. Chapter 4 • Statement of earnings (SOE) format and content elements • Items that are either unusual or infrequent, but not both • Special treatment items • Discontinued operations • Extraordinary events • Accounting changes A&MIS 521

2. Statement Format • The multi-step statement is the preferred statement from my perspective (see Exhibit 6-2) • The single-step statement is acceptable, but less preferred. A&MIS 521

3. Elements of SOE • Sales and operating revenues • Cost of goods sold • Operating expenses • Non-operating items • Provision for income taxes • Special reporting items • Net income A&MIS 521

4. SOE: Operating Section Revenues $ RRRR Cost of goods sold COGS Gross margin $ MARG Selling expenses $ SEXP Administrative expenses ADEX EXPN Income from operations $ IO.IO A&MIS 521

5. SOE: Non-Operating Section Income from operations $ IOIO Other income and gains: Gain on sale of building GAIN Other expenses and losses: Interest expense $ INTR Loss on sale of equipment LOSS ( LOSS) Income before tax $ IBTX Provision for income taxes FITX Income from continuing activities $ NICA A&MIS 521

6. SOE: Special Item Section Discontinued operations (net of related taxes) DISC Extraordinary gains (losses) (net of related taxes) EXTRA Cumulative effect of a change in accounting principle (net of related taxes) CHANGE Net income $ NETIN A&MIS 521

7. SOE: Special Item Section Now, let us consider in more detail the three items that receive separate, special treatment in the statement of earnings. A&MIS 521

8. Discontinued Operations • Objective is to communicate to investors the impact on assets, liabilities, and income that is associated with the disposal of a line of business or major class of customers. A&MIS 521

9. Discontinued Operations--II • Income from operations and gains or losses on the disposal of a line-of-business must be shown separately from the results of continuing operations. • The operating component consists of the total revenues, expenses, gains, and losses up to the measurement date (plan adoption) A&MIS 521

10. Discontinued Operations--III • The disposal component consists of the sum of the revenues, expenses, gains, and losses after the measurement date (plan adoption) • Reported net of income taxes A&MIS 521

11. Extraordinary items • Must be unusual in nature in the operating environment involved • Must be infrequent in the recent history of the reporting entity • One notable exception to the above requirements includes the gain or loss on the early retirement of debt. • Reported net of income taxes A&MIS 521

12. Accounting Changes • Change in an accounting method (principle) • Change of an accounting estimate • Change in an accounting entity • Except for a change of an estimate, the above are reported net of income taxes A&MIS 521

13. Change in an accounting method (principle) • Change from one GAAP method to another • The new method is adopted as of the beginning of the fiscal year. • Current operating results are reported under the method newly adopted. • Effects on prior periods reported using either the current or the retroactive approaches. A&MIS 521

14. Why change accounting methods? • If FASB issues a new standard, some or all companies may have to change their accounting for affected transactions. • Suppose an item was accounted for using a non-GAAP method, but was immaterial. If that item becomes material, then it would have to be reported in accordance with GAAP A&MIS 521

15. Why change methods? • Companies in a competitive industry may voluntarily change methods to be more in line with their competitors. Uniform reporting within an industry is believed to enhance comparability. • If an items goes from being immaterial to being material, changing to a GAAP method is not a change in methods. A&MIS 521

16. What do we do (usually)? • The new method is effective as of first day of the year of the change. • The effects of the new method on the income of the year of the change must be disclosed in the footnotes or supplementary information. A&MIS 521

17. What do we do (usually)? • Cumulative difference in income as between using the new method and the previous one is reported as an element of income during the period of the change. • Certain income and per-share figures for all prior periods included in a report must be disclosed as if the new principle were in effect during those periods. A&MIS 521

18. What we do not do • The statements from prior years are unchanged. A&MIS 521

19. Accounting Errors • Errors arise from a variety of causes. • Mathematical errors • Using an accounting principle not in conformity with GAAP • Applying a GAAP incorrectly A&MIS 521

20. Accounting Errors--II • Disregarding or misusing facts that existed at the date the financial statements were prepared, including the deliberate manipulation of estimates. A&MIS 521

21. Correction of an Acct. Error • Errors discovered in the same period they are made are simply corrected when discovered. No special reporting is required since the correction is made before external users see the information. • Unintentional errors from a prior period are reported in the period discovered A&MIS 521

22. Correction of an Acct. Error • Reported net of federal income tax • Reported in a statement of retained earnings as an adjustment to beginning balance of Retained Earnings. The correction of an error does not affect the determination of periodic income. • Some errors, such as inventory errors, may be self-correcting over time. A&MIS 521

23. Accounting Estimates • Estimates must be made in the normal course of recognizing revenue and measuring expenses. Such estimates are unavoidable if we are to provide meaningful information to statement users when the information is needed to make timely decisions. Business involves risk and uncertainty! A&MIS 521

24. Examples from A&MIS 521 • Provision for doubtful accounts (AMIS 211) • Estimates of useful lives of depreciable assets (ch. 5) • Estimates of salvage values of depreciable assets (ch. 5) • Estimates of total contract expenses for the percentage-completion method of recognizing revenue (ch 4) A&MIS 521

25. More Examples • Estimates of warranty service costs when recognizing revenue from the sale of manufactured products (ch. 4) • Estimates of the costs of warranty services when recognizing income from warranty contracts (ch.4) • Provisions for contingent obligations for environmental damage (ch.3) A&MIS 521

26. What do we do? • Accounting estimates of material costs should be reevaluated regularly. • When revisions are necessary, all future reports should reflect the revised estimates. These estimates will be used until revised again. • Revisions that materially affect results should be explained in a footnote. A&MIS 521

27. What we do not do. • The effects on prior years of estimate revisions are not disclosed. The idea is that if we constantly revise earlier reports, confidence in accounting statements will be reduced. • The financial statements do not include any “special” items, beyond footnote disclosure, to report even the material effects of changes in estimates. A&MIS 521

28. Why do estimates change? • Economic conditions change • Changes in technology or methods may change the useful lives of depreciable assets, for example. • New information becomes available • We learn and better understand what we could have known before but did not A&MIS 521

29. THE END A&MIS 521