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FINANCIAL STATEMENT INFLUENCES

FINANCIAL STATEMENT INFLUENCES. Chapter 6. CHAPTER 6 OBJECTIVES. Indicate how judgment influences financial statement disclosures. Distinguish between revenue and capital expenditures; product and period costs; fixed and variable costs; and controllable and uncontrollable costs.

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FINANCIAL STATEMENT INFLUENCES

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  1. FINANCIAL STATEMENT INFLUENCES Chapter 6

  2. CHAPTER 6 OBJECTIVES • Indicate how judgment influences financial statement disclosures. • Distinguish between revenue and capital expenditures; product and period costs; fixed and variable costs; and controllable and uncontrollable costs. • Determine how various cost classifications affect financial statement analysis.

  3. CHAPTER 6 OBJECTIVES (CONT.) • Describe how managerial choices affect reported numbers and discuss ways to validate the integrity of those choices • Articulate the value of a standard unqualified audit report to analysis. Understand why adverse reports, disclaimers of opinions, and going concern questions limit analysis.

  4. FINANCIAL REPORTING JUDGMENT • Judgments related to financial reporting inputs • Generally accepted accounting principles (GAAP) • Regulation by the Securities and Exchange Commission (SEC) • Managerial choices about alternative accounting methods • Nominal dollar concept of capital maintenance

  5. FINANCIAL REPORTING JUDGMENT (CONT.) • Judgment related to financial statement analysis • Analytical judgment—the ability to reach informed opinions about financial statements and related disclosures • Requires a logical interpretation of economic reality

  6. BASIC COST CONSIDERATIONS • Economic sacrifice made to acquire something of value; assists in wealth maximization; and disclosures depend on GAAP (revenue versus capital expenditures) and industry (e.g., manufacturing versus retail businesses)

  7. BASIC COST CONSIDERATIONS (CONT.) • Revenue expenditures • Costs that produce revenues in the current reporting period • Treated as an expense on the income statement • Capital (asset) expenditures • Costs that produce revenues in the current and future reporting periods • Treated initially as an asset on the balance sheet • Expensed in a systematic manner as a portion of the asset is used in generating periodic revenues

  8. BASIC COST CONSIDERATIONS (CONT.) • Capital and revenue expenditures • Required disclosures sometimes deviates from theoretical basis (e.g., reporting research and development costs as a revenue expenditure) • Managerial behavior sometimes influences disclosures (e.g., adjustment of lease terms so that lessee reports leased assets as revenue expenditures)

  9. BASIC COST CONSIDERATIONS (CONT.) • Product and period costs (Exhibit 6-1) • Product costs—inventory-related costs, reported as capital expenditures • Period costs—noninventoried costs, reported as revenue expenditures

  10. BASIC COST CONSIDERATIONS (CONT.) • Industry influences reporting for certain product and period costs • Merchants have only one type of inventory: finished goods • Manufacturers have three types: raw materials, work in process, and finished goods • A merchant’s costs incurred with selling inventory (e.g., salaries and depreciation) are period costs • A manufacturer’s costs incurred in converting inventory to its finished state (e.g., salaries and depreciation) attach to the cost of the inventory and are product costs

  11. OTHER COST FACTORS • Cost control • Controllable cost—one that can be controlled or heavily influenced by managerial decisions; also known as discretionary costs • Uncontrollable cost—one that cannot be controlled in the short run; also known as a discretionary cost • Managerial decisions about discretionary costs influences short and long-term profitability (e.g., spending on research and development or advertising)

  12. OTHER COST FACTORS (CONT.) • Cost behavior • Fixed costs—dollar amount remains constant in total, regardless of sales level; cost per unit is inversely related to sales volume • Variable costs—dollar amount is constant on per unit basis; total costs change in direct proportion to changes in sales volume

  13. OTHER COST FACTORS (CONT.) • Breakeven point—activity level where revenues equal total fixed and variable costs • Capital intensive industries tend to have a higher breakeven point than labor intensive ones, but they tend to reap greater profit on per unit basis once the breakeven point is surpassed. • Investing decisions (e.g., for plant and equipment) alter an entity’s breakeven point (Exhibit 6-2A and B) • Industry specific measures sometimes help with cost-volume-profit analysis (e.g., the airline industry’s disclosures of passenger load

  14. OTHER COST FACTORS (CONT.) • Cost composition • Influenced by the mix of products sold by an entity. • Different products have different cost structures yielding different profit margins • Current product composition affects net income • Changes in product composition alter profitability

  15. OTHER COST FACTORS (CONT.) • Income statements do not disclose costs by level of control, behavior, or composition

  16. MANAGERIAL JUDGMENTS AND ESTIMATES • Companies should report representationally faithful financial statements; financial reporting latitude allows reporting alternatives; aggressive accounting or fraudulent reporting overstates income and results in a misallocation of resources

  17. MANAGERIAL JUDGMENTS AND ESTIMATES (CONT.) • Accounting methods • Primary qualitative characteristics—relevance and reliability • Analytical issue: companies sometimes must trade relevant disclosures for reliable ones or vice-versa

  18. MANAGERIAL JUDGMENTS AND ESTIMATES (CONT.) • Secondary qualitative characteristics—consistency (over time) and comparability (among firms) in financial disclosures • Analytical issue: inconsistency or incomparability hinder analysis; data should be adjusted to insure valid benchmarking

  19. MANAGERIAL JUDGMENTS AND ESTIMATES (CONT.) • Estimation of future events • Needed to properly allocate capitalized costs • Managerial judgment required in a highly uncertain environment (i.e., the future)

  20. MANAGERIAL JUDGMENTS AND ESTIMATES (CONT.) • Revenue recognition policy • Based on two factors: • Revenue realization occurs when goods or services are exchanged for cash or claims to cash • Revenues are earned when an entity has fulfilled its obligations and is entitled to the attendant economic benefits

  21. MANAGERIAL JUDGMENTS AND ESTIMATES (CONT.) • Revenue recognition policy • Problem—judgment is involved as to when revenues are realized and earned • Potential exists for premature revenue recognition (front-end loading of revenues) • Defenses—careful analysis and evaluation of current information

  22. MANAGERIAL JUDGMENTS AND ESTIMATES (CONT.) • Matching of expenses to revenues • Expenses should be recognized in the period revenues are earned (i.e., matched against revenues or reported as incurred) • Problem—judgment is involved as to when expenses are incurred • Potential exists for deferring expense recognition (back-end loading of expenses) • Defenses—careful analysis and evaluation of current information

  23. AUDIT OPINIONS • Independent expression of the fairness of financial statements in accordance with generally accepted accounting principles

  24. AUDIT OPINIONS (CONT.) • Types of audit reports • Standard unqualified report—provides greater assurance to the analyst than the other types of opinions; also known as a clean opinion • Qualified report, due to a departure from GAAP • Adverse report—lack of conformity with GAAP (gross GAAP departures)

  25. AUDIT OPINIONS (CONT.) • Types of audit reports (cont.) • Qualified report, due to a limitation or audit procedures (scope) • Disclaimer of report—inability to render an opinion because sufficient evidence could not be obtained (gross scope limitations)

  26. AUDIT OPINIONS (CONT.) • Other audit considerations: • Explanatory language—describes the circumstances why an unqualified opinion was not rendered • Going concern issue—auditor questions whether an entity can continue in the normal course of business, regardless of the type of audit opinion they issue

  27. APPLE COMPUTER AND THE PC INDUSTRY • PC companies reported economic events on a comparable and consistent basis • Inventory reductions reduced potential issues related to cost considerations

  28. APPLE COMPUTER AND THE PC INDUSTRY (CONT.) • Research and development costs are significant in the industry, but they are immediately expensed in accordance with GAAP; the analyst should monitor R&D spending and impact on income • Entities received unqualified audit opinions during the period analyzed

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