FINANCIAL%20STATEMENT%20INFLUENCES

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FINANCIAL STATEMENT INFLUENCES

• Chapter 6

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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.

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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.

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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

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FINANCIAL REPORTING JUDGMENT (CONT.)

• Judgment related to financial statement analysis
• Analytical judgmentthe ability to reach informed
  opinions about financial statements and related
  disclosures
• Requires a logical interpretation of economic
  reality

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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)

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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

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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)

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BASIC COST CONSIDERATIONS (CONT.)

• Product and period costs (Exhibit 6-1)
• Product costsinventory-related costs, reported
  as capital expenditures
• Period costsnoninventoried costs, reported as
  revenue expenditures

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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 merchants costs incurred with selling
  inventory (e.g., salaries and depreciation) are
  period costs
• A manufacturers 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

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OTHER COST FACTORS

• Cost control
• Controllable costone that can be controlled or
  heavily influenced by managerial decisions also
  known as discretionary costs
• Uncontrollable costone 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)

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OTHER COST FACTORS (CONT.)

• Cost behavior
• Fixed costsdollar amount remains constant in
  total, regardless of sales level cost per unit
  is inversely related to sales volume
• Variable costsdollar amount is constant on per
  unit basis total costs change in direct
  proportion to changes in sales volume

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OTHER COST FACTORS (CONT.)

• Breakeven pointactivity 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 entitys breakeven point
  (Exhibit 6-2A and B)
• Industry specific measures sometimes help with
  cost-volume-profit analysis (e.g., the airline
  industrys disclosures of passenger load

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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

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OTHER COST FACTORS (CONT.)

• Income statements do not disclose costs by level
  of control, behavior, or composition

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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

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MANAGERIAL JUDGMENTS AND ESTIMATES (CONT.)

• Accounting methods
• Primary qualitative characteristicsrelevance and
  reliability
• Analytical issue companies sometimes must trade
  relevant disclosures for reliable ones or
  vice-versa

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MANAGERIAL JUDGMENTS AND ESTIMATES (CONT.)

• Secondary qualitative characteristicsconsistency
  (over time) and comparability (among firms) in
  financial disclosures
• Analytical issue inconsistency or
  incomparability hinder analysis data should be
  adjusted to insure valid benchmarking

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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)

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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

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MANAGERIAL JUDGMENTS AND ESTIMATES (CONT.)

• Revenue recognition policy
• Problemjudgment is involved as to when revenues
  are realized and earned
• Potential exists for premature revenue
  recognition (front-end loading of revenues)
• Defensescareful analysis and evaluation of
  current information

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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)
• Problemjudgment is involved as to when expenses
  are incurred
• Potential exists for deferring expense
  recognition (back-end loading of expenses)
• Defensescareful analysis and evaluation of
  current information

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AUDIT OPINIONS

• Independent expression of the fairness of
  financial statements in accordance with generally
  accepted accounting principles

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AUDIT OPINIONS (CONT.)

• Types of audit reports
• Standard unqualified reportprovides 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 reportlack of conformity with GAAP
  (gross GAAP departures)

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AUDIT OPINIONS (CONT.)

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

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AUDIT OPINIONS (CONT.)

• Other audit considerations
• Explanatory languagedescribes the circumstances
  why an unqualified opinion was not rendered
• Going concern issueauditor questions whether an
  entity can continue in the normal course of
  business, regardless of the type of audit opinion
  they issue

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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

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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 RD spending and impact on income
• Entities received unqualified audit opinions
  during the period analyzed