CH-9-12 Uniformity and Disclosure Some Policy-Making Directions – Accounting Theory: Conceptual Issues in a Political and Economic Environment : Book Guide

This Document Contains Chapters 9 to 12 Chapter 9: Uniformity and Disclosure: Some Policy-Making Directions CHAPTER HIGHLIGHTS It is extremely important in this chapter to make sure that definitions of concepts are well understood. The first important distinction is between simple and complex events. How relevant circumstances can affect complex events is the next link. Examples of the two types of relevant circumstances (present magnitudes and future contingencies) should help to reinforce the concept. With these various definitions and distinctions in mind, the two types of uniformity can then be examined. The point should be stressed that finite uniformity is not “better” than rigid uniformity. Which one would be preferable is very definitely a cost versus benefits question. Part of the cost of implementing finite uniformity would be a more extensive standard-setting apparatus than would be the case with rigid uniformity. Hence, finite versus rigid uniformity is very much a cost-benefits-oriented question. Finite and rigid uniformity, as total systems, represent ideal types. Nevertheless, a better understanding of current standards can be acquired if they are analyzed from the standpoint of finite and rigid uniformity. A third orientation, flexibility, is also present where several methods are allowed and no relevant circumstances are present. Since disclosure is becoming more important in light of increasing transaction (event) complexity as well as the impact of the efficient-markets hypothesis, and also has implications relative to the uniformity issue, it is examined in the last part of the chapter. The most important aspect of disclosure is the shift from protective to informative disclosure, which appears to be taking place at the SEC. While not much is said about the extensive growth of disclosure, it is certainly worthy of class discussion. The chapter contains an extensive discussion of disclosure and also lists and discusses different methods of disclosure. The difference between selective and differential disclosure is discussed as well as arguments in favor of more or less disclosure. Forms and methods of disclosure include management’s discussion and analyses, signalling and management earnings forecasts, segmental disclosures (the Jenkins Committee Report and SFAS No. 131), and quarterly information. QUESTIONS Q-1 Is Cadenhead’s conception of circumstantial variables as the only permissible departure from prescribed accounting methods closer to finite or rigid uniformity? Cadenhead’s conception of circumstantial variables is more narrow in scope than the concept of relevant circumstances discussed in the chapter. Departures from the rigidly prescribed accounting methods are intended to be very infrequent. Therefore, though his approach falls be- tween finite and rigid uniformity, his intention is to be closer to rigid uniformity. Chapter 9: Uniformity and Disclosure: Some Policy-Making Directions This Document Contains Chapters 9 to 12 Q-2 Do you think management policies should be acceptable as potential relevant circumstances? Why or why not? Obviously, either side of the issue can be taken. Our position would be only insofar as management policies involve a choice among relevant circumstances. For example, a managerial choice between a lease for 60 percent of the economic life of an asset versus a 90 percent lease involves a choice among relevant circumstances, at least in terms of the way SFAS No. 13 defines the problem. The situation becomes more difficult where future contingencies are involved, because either managerial judgment or managerial policy implications are involved. It is highly questionable whether management can be expected to be unbiased in these situations. The long-run reward for “good” financial reporting by management can hardly be expected to govern in these situations. Q-3 How do present magnitudes differ from future contingencies? The time dimension is the difference, of course. Under present magnitudes, the relevant circumstances are present in the nature of the transaction, which is accepted as a surrogate or indicator of different cash flows. In the case of future contingencies, the nature of the event leading to cash flow differential itself must be relied upon. Future contingencies may thus be less verifiable than present magnitudes. Q-4 Are simple transactions really examples of rigid uniformity? Why or why not? Since no relevant circumstance differentials are present in simple event situations, their treatment should be the same as rigid uniformity. The significance of rigid uniformity is its usage in complex event situations. Q-5 Finite and rigid uniformity would result in different information being received by users of financial statements. What difference would this make in terms of resource allocation when viewed from a macroeconomic standpoint? It would be hoped that the additional information provided by finite uniformity, which would affect security prices, would result in a more accurate portrayal of the risk-return configuration of securities. As a result, it would be hoped that resources would be allocated more efficiently. Of course, the cost involved to attain the more efficient allocation of resources concerns the cost of producing the presumed better quality of information. Hence, we have an extremely difficult information economics problem. Q-6 Why does segment disclosure in SFAS No. 131 represent a potential improvement over segment disclosure in SFAS No. 14? SFAS No. 131 is supposed to result in segment reporting along the lines that enterprise management itself uses rather than the more arbitrary and flexible approach of SFAS No. 14. Q-7 How do protective and informative disclosures differ? Protective disclosure assures that unsophisticated investors are not treated unfairly. Informative disclosure provides the full range of information useful for investment analysis purposes. The primary difference is the financial sophistication of the user groups. Q-8 Under previous disclosure requirements of the SEC, dividends paid during the past two years to shareholders must be stated in the annual report. This requirement has been broadened: There must be disclosure of any restrictions on the firm’s present or future dividend- paying ability. If the firm has not paid dividends in the past despite the availability of cash, and the corporate intention is to continue to forgo paying dividends in the foreseeable future, disclosure of this policy is encouraged. If dividends have been paid in the past, the firm is encouraged to disclose whether this condition is expected to continue in the future. Do you think that this broadening of disclosure of dividend policy is primarily protective or informative? Discuss. There is, of course, some overlap between protective and informative disclosure. The broadening of disclosure of dividend-paying policy appears to be more protective since the information is particularly important to those who might be relying on the hope of immediate dividend payments. There are informative aspects of this information. Why is the firm following its particular dividend policy? For example, is its financial situation endangered, or is it expanding using internally generated funds? A retained earnings restriction might also convey the latter information. Q-9 ASR 242 of the SEC states that relative to payments made to foreign governmental and political officials, “. . . registrants have a continuing obligation to disclose all material information and all information necessary to prevent other disclosures made from being misleading with respect to such transactions.” This ASR appeared shortly after the passage of the Foreign Corrupt Practices Act. Do you think this type of disclosure is primarily protective or informative in nature? Businesses subject to the Foreign Corrupt Practices Act must provide systems of internal control in terms of maintaining accountability for assets and ensuring that transactions are in accordance with management’s authorization; access to assets is permitted only to those having proper authority. Obviously, information of the type required by the Act is concerned with protective elements, since it pertains to appropriate internal controls relative to foreign business. At the same time, information of this type can provide much insight into a company’s mode of operation. Hence, the main thrust of the disclosure is protective, but it can also be highly informative if a breakdown in the firm’s internal controls occurs and is disclosed. Q-10 If uniformity means eliminating alternative accounting treatments, then surely comparability of financial statements of different enterprises would be improved. Do you agree with this statement? Comment. The sense of uniformity in the statement is rigid uniformity. Where methods are restricted, the results are not necessarily more comparable because of possibilities of different circumstances being present despite the same method being used. Of course, rigid uniformity could result in better comparability when compared with a situation of flexibility. Q-11 Is the choice of LIFO a relevant circumstance compared to FIFO? On their own the choice would not be a relevant circumstance. The choice would not affect actual inventory flows. The switch would really be nothing more than a choice among allocations. However, the choice involves a change in cash flows relative to income tax payments. Hence it would be a relevant circumstance although we do not like to see relevant circumstances arising from tax considerations. Q-12 Do you agree that it is not necessary to provide information for undiversified investors? Discuss. It is not clear what information would be specifically applicable to undiversified stock owners that would not be useful to diversified shareholders as well. Q-13 SFAC No. 6 defines circumstances as follows: Circumstances are a condition or set of conditions that develop from an event or series of events, which may occur almost imperceptibly and may converge in random or unexpected ways to create situations that might otherwise not have occurred and might not have been anticipated. To see the circumstance may be fairly easy, but to discern specifically when the event or events that caused it occurred may be difficult or impossible. For example, a debtor’s going bankrupt or a thief’s stealing gasoline may be an event, but a creditor’s facing the situation that its debtor is bankrupt or a warehouse’s facing the fact that its tank is empty may be a circumstance. How does this definition of circumstances relate to the definition of relevant circumstances presented in the chapter? Circumstances, as defined in SFAC No. 6, may or may not entail relevant circumstances as the term is defined in the chapter. The situations described in SFAC No. 6 all entail changes in cash flows hence they are relevant circumstances that require event recognition. What they do not entail, however, is a choice among alternative accounting methods involving choices of how to recognize the event. Q-14 SFAS No. 13 in effect regards a lease period of 75 percent or more as a relevant circumstance in distinguishing between capital and operating leases. What economic factors (cash flow differentials) lie behind this policy choice? At least as the FASB sees it, where the asset is leased for more than 75 percent of its economic life, the lessee is closer to an owner in terms of risk considerations. This would probably mean a lower cost per unit of usage of the leased asset’s services, but less flexibility if the asset becomes partially obsolescent. As noted in the text, the 75 percent benchmark may be very arbitrary in nature. Q-15 An argument against additional disclosure is that financial analysts aggressively seek this information, which is then sold to their customers, resulting in an adequate market solution to the problem of providing timely and relevant information on securities. Do you agree? Certainly, as Brownlee and Young have argued, while accounting information is a public good, those who acquire it from financial analysts do have the time utility benefit of acquiring it first. This is at least a partial market solution to the problem. The issue raised by Lev, however, is a powerful one. Those who do not have information or do not have it on a timely basis will tend to take defensive actions, even extreme ones such as getting out of the market. As a result, those having the benefit of information might be operating in a “thin” market and would not tend to receive the benefits of their information advantage. Hence, even these individuals would benefit from additional disclosure. Q-16 What are the possible benefits of a disclosure process that is integrated with major policies in marketing, production, and finance? Do you think only “good news” items should be disclosed? Lev sees an integrated disclosure policy leading to a reduction of uncertainty over the long run, which should, therefore, lead to higher security prices. Of course, the release of “bad news” (as opposed to not releasing it) can lead to lower security prices in the short run. The general perception of being an “information discloser” should, over the long run, lead to greater confidence in the firm and its management. Q-17 Do you think that disclosures of smaller firms have more information content than disclosures for larger firms? Yes. The reason is that there is significantly less publicly available information about smaller firms than larger firms. Q-18 What is meant by the term “degrees of representational faithfulness?” The term degrees of representational faithfulness refers to a relative rather than an absolute view of representational faithfulness. Sterling (1985) is an exemplar of the absolute approach: it either is or is not representationally faithful, although even he admits to measurement difficulties. However, in the absolute mode, there could be no trade-off between relevance and reliability. Representational faithfulness, in effect, covers both categories. Finite uniformity represents the relative approach. Some measurements are better than others in terms of representational faithfulness, and a choice among methods involves trade-offs between relevance and reliability. A “successful efforts” approach to research and development costs would be more representationally faithful than SFAS No. 2, but it could add significantly to verifiability problems. (We personally would favor this treatment, but that is not the issue.) Q-19 Firm A and B are exactly the same size as are Firm C and Firm D. Firm A acquires for cash 100 percent of the common stock of Firm C. Firm B acquires 100 percent of Firm D by exchanging one share of its own stock for each share of common stock of Firm D. Are there differences in relevant circumstances between these two transactions? Explain. This is a somewhat loaded question which is asking whether purchase and “pooling” are really different transactions requiring different accounting approaches. By way of analogy, assume a fixed asset were being acquired by means of (1) cash or (2) some amount of the acquiring firm’s common stock given in exchange for the asset. In both cases we would value the asset acquired in terms of the value of the consideration given up but there would be no different form of accounting for the acquired asset. We might want to use a different method of depreciation based on how we were going to use the asset but how the asset was acquired would be irrelevant. In other words consideration given up to acquire an asset or assets might affect the determination of the value of the asset but would not lead to a different method of valuation (purchase price versus historical cost). Relevant circumstances pertain to how an asset is controlled or used up but not to how much was given to acquire it. Q-20 How do Lev’s views on disclosure differ from the views of Brownlee and Young? Lev is in favor of publicly disseminating as much corporate information as possible to eliminate insider information. He feels that this will prevent markets from getting “thin.” Brownlee and Young favor disseminating information through financial analysts who will aggressively seek this information and sell it to clients. However, this is a form of selective disclosure and not all “players” will have this information. Hence Brownlee and Young would put information on a “supply and demand” basis. Market value of securities, however, would not be based on information symmetry. Q-21 Distinguish between the discrete and integral views of quarterly information disclosure. The discrete view sees each quarterly period as standing on its own whereas the integral view sees the quarter as part of a larger whole: the fiscal year. Q-22 What evidence supports the statement that SFAS No. 131 is an improvement over SFAS No. 14? There has been a reduction in the number of firms claiming they only operate in one segment. In addition, the average number of segments reported has increased per firm. Also, the number of items reported per segment has increased. Firms have also changed the definition of their schedules to presumably show them in accordance with management’s own internal analysis but this could be an attempt to hide relevant information. All in all, SFAS No. 131 does appear to have brought improvements to segment reporting. CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1. Refer to either a current intermediate accounting text or a guide to current “generally accepted accounting principles.” Give at least one example for each of the four cells of Exhibit 9-1 (your instructor may desire to modify this problem). Cell IA (relevant circumstances and finite uniformity) SFAS No. 13 uses the 75 percent rule relative to the proportion of the estimated economic life that the asset is leased for (costs should be lower the longer the lease period extends, but we would still prefer to use rigid uniformity and capitalize all long-term leases). SFAS No. 19 (superseded by SFAS No. 25) requires successful efforts because write-off of drilling costs occurs for dry holes and capitalization occurs for productive holes. Cell IB (relevant circumstances and rigid uniformity) • SFAS No. 86 requires the expensing of software development costs until the point where “technological feasibility” is attained, even though these costs have a higher probability of generating future cash flows than research and development costs. Cell IIA (no relevant circumstances with finite uniformity: this is really flexibility) • FIFO, LIFO, and weighted average inventory methods holding aside tax issues. • APB Opinion No. 10 for installment accounts where either accrual or cash method can be used. • Straight-line or effective interest method can be used for amortization of bond premium or discount. Cell IIB (no relevant circumstances with rigid uniformity) APB Opinion No. 21 for notes without a specified interest rate must be discounted. SFAS No. 4 on refunding of long-term debt requires that gains and losses must be treated as extraordinary gains or losses. 2. Compare and contrast the Hutton (2004) and Lev (1992) disclosure strategies. Lev, Baruch (Summer 1992). “Information Disclosure Strategy.” California Management Review, Summer 1992, pp. 9-32. Hutton, Amy (Fall 2004). “Beyond Financial Reporting: An Integrated Approach to Corporate Disclsoure.” Journal of Applied Corporate Finance, pp. 8-16. The comparison covers Lev’s voluntary disclosure strategy versus Hutton’s mandated data and disclosure. 3. Give as many examples as you can of flexibility under current generally accepted accounting principles. As noted in the text, the investment tax credit (aside from any carryforward aspects), inventories, and treasury stock involve no differences in relevant circumstances; hence, they are classic examples of flexibility. Depreciation is a special case because different usage patterns might involve relevant cash flow differentials, but these have not been used by standard setters. A free choice exists among selection of methods, such as straight-line, sum-of-the-years’-digits, and fixed percentage of declining balance. Marketable debt securities prior to SFAS No. 115 provide an interesting de facto case of flexibility. SFAS No. 12 states that marketable equity securities are to be carried at lower-of- cost-or-market, while marketable debt securities are not mentioned in the standard. While some authors believe implied preference exists in SFAS No. 12 for carrying all temporary investments at lower-of-cost-or-market, treatment of marketable debt securities by either cost or lower-of- cost-or-market was acceptable. Since no relevant circumstantial differences are present, the result is one of flexibility. SFAS No. 19 attempted to eliminate full costing in the oil and gas industry in favor of only one method, successful efforts. Accounting Series Release 253 of the SEC permitted either method, and SFAS No. 25 then rescinded SFAS No. 19, leaving an unfettered choice between full costing and successful efforts. For further coverage, see Chapter 15. It is very unclear that legitimate relevant circumstances exist in terms of differentiating between purchases and poolings. Consequently, the situation was to be one of flexibility. Pooling is now gone. Another example involves bonds payable. Premium or discount can be amortized on either a straight-line basis or the effective interest basis. Finally, revenue on installment sales is supposed to be recognized in the period of sale, but if the uncollectability factor is too difficult to estimate, gross profit can be recognized in accordance with the collection of installment receivables. Theoretically, this falls under the category of Cadenhead’s circumstantial variables, but in practice it may break down into flexibility. 4. SFAS No. 115 defines held-to-maturity securities as debt securities that the firm “has the positive intent and ability to hold those securities to maturity.” Trading securities “are bought and held principally for the purpose of selling them in the near term....” Available-for-sale securities are simply everything else. SFAS No. 115 requires held-to-maturity securities to be valued at amortized cost with the other two carried at fair value. Unrealized gains and losses on trading securities are recognized in net income but for trading securities unrealized gains and losses are recognized as other comprehensive income and as a separate part of owners’ equity. Two members of the FASB voted against the standard. They wanted the three types of securities to be carried at market value and unrealized gains and losses of the three “types” to go through income. Required: Evaluate the Board’s attempt to use a finite uniformity approach to the investments covered in the standard. How did the dissenters to SFAS No. 115 want to deal with the problem? This is what we would call phoney finite uniformity. The finite uniformity being employed is based on managerial intent which is not a good way to go. Why an intent – which may or may not materialize – should result in bond investments to be carried at cost if this is an intent to hold them to maturity is not clear. It would avoid “Messy” unrealized gains or losses but why this would be a benefit is not clear. The difference between trading securities and available-for-sale securities is so tenuous that the different treatment for unrealized gains and losses is in our opinion, totally unjustified. The two dissenters desire to use market value for all three “types” of investments and similar treatment of unrealized gains and losses – in other words rigid uniformity makes perfectly good sense to us. 5. Cadenhead presented an approach to uniformity referred to as circumstantial variables. Circumstantial variables are environmental conditions (conditions beyond the control of the individual firm that are applicable to the particular industry that the firm is in). Circumstantial variables lead to problems relative to either (1) costliness of the prescribed method in the particular event situation or (2) a low degree of verifiability because estimates vary widely relative to the prescribed method. For example, Cadenhead notes that the existence of a ready market with regularly quoted prices would facilitate inventory valuation if realizable value were not used relative to inventories, but the absence of such a market would allow a firm to use another type of inventory/cost of goods sold measurement. In the four situations discussed here, classify each situation according to whether it involves finite uniformity, rigid uniformity, flexibility, or circumstantial variables. Research and development costs: SFAS No. 2 requires that all research and development costs (some of which will have future cash flow benefits and others will not) be written off to expense as incurred. Are there any other accounting principles that are present here? Discuss. Unusual right of return by customers: SFAS No. 48 covers those industries (of which there are not many) where buyers have an unusual right of return due to industry practices that cannot be avoided by the individual firm. The “unusual right of return” arises where buyers have an unusually long time period during which purchase returns can be made. From the seller’s standpoint, revenue is recognized at time of sale, provided that the future returns can be reasonably estimated (there are five other conditions that must also be met but they are of no concern here). If sales returns cannot be reasonably estimated, then sales revenues are not recognized until returns can be reasonably estimated or (more likely) the return privilege has substantially expired. Hence, it is not cash flow differences that are at issue but rather the ability to estimate the expected returns that is the key point. Investment tax credit (assume no investment tax credit carryforward problem): All of the cash benefits in the form of lower taxes are received in the year of asset acquisition. The enterprise may recognize benefit (in the form of lower tax expense) in the year of acquisition or the benefits may be spread over the life of the asset in the form of lower annual depreciation. Oil and gas accounting: SFAS No. 19 tried to allow only “successful efforts.” In successful efforts, the costs of dry holes must be written off once it is known that the holes are dry. If (and only if) a well were successful, drilling costs would be capitalized and amortized over future years. a. This would be an example of rigid uniformity because capitalization is not attained even if future cash flows materialize. Immediate expensing must occur regardless of future cash flow prospects. This would also be an example of conservatism and also results in a higher degree of verifiability. b. This is a case of a circumstantial variable. One industry where this situation arises is book publishing. It is customary in the industry to allow a very long period for returns, so it is beyond the control of any single firm within the industry to break with this practice. The inability to reasonably estimate future returns is the second aspect of circumstantial variables, the feasibility (low degree of verifiability) of making the required measurement. c. This would be a situation of flexibility because one situation exists relative to receipt of cash flows, but one of two methods can be used as the firm desires. d. This is finite uniformity because successful efforts requires writing off the costs of drilling if no oil or gas is there, but it would require capitalization if gas or oil is present. Hence, future cash flows dictate the accounting treatment. Students frequently answer this as rigid uniformity because they see one method and two cash flow possibilities. Of course, the method has a built in “branching”: expense if no future cash flows, but capitalize if future cash flows are present. Successful efforts is more conservative than full costing, which is more liberal relative to capitalization of lease costs. 6. Colleges and universities frequently get graduating seniors to donate money to them. A very common practice is to divide this money up over a number of years. Thus a $30 donation might be divided up over a five year period (based on a Wall Street Journal article of March 2, 2007; the $30 contribution and the $6 division over five years was actually cited in the article). Required: Is this an allocation? Discuss. Why do you think that colleges and universities follow this practice? What entry did the college make for the five year division? Do you have any other comments you would like to make about this practice? Golden, Daniel (2007). “To Boost Donor Numbers, Colleges Adopt New Tricks,” The Wall Street Journal, March 2, 2007: page A1. a. An allocation is a "slicing up" or dividing of costs or revenues arising in one period which are applicable to many periods. The key question to ask relates to the donor’s intentions when the gift was made. If the donor clearly indicates that this is a multi-year gift, an allocation would likely make sense to match the gift with the periods in which the intentions cover. However, the tenor of the article indicates this is not the case. If so, we would classify this practice as manipulation, not allocation. b. From managerial accounting, “What you measure is what you get.” Program rankings may include alumni-giving rates to the university. It is likely more easy to manipulate the metric than to actually increase the percentage of alumni giving. The manipulated metric may result in an improved ranking, increased prestige, and higher demand for the university or college’s programs. For those institutions “playing by the rules” and producing “true” alumni-giving rates, they are actually penalized for their honesty. c. The college likely accounted for the donation by debiting cash and crediting a “future years contribution” account. Each year during the 5-year period, the accountant adjusts the future years contribution account, assigning a portion to the current year alumni-giving. d. This should foster some good in-class discussion. Some organizations require annual fees to be an alumni member; however, they may also offer a one time fee for a lifetime membership (e.g., Fulbright Alumni Association). What should the accounting be in this instance? If colleges clearly communicate that this is a “lifetime” request for donations from alumni and that no future requests will ever be made, how should the contribution be booked? Assume that an individual names the college as beneficiary to a life insurance policy that he/she pays the annual premium. How should it be accounted for each year? What if it is a single premium policy, the donor is 30 years old, and no additional policy premiums are made? Should the annual alumni-giving percentage include this life insurance donor only one year or for all future years until his/her death? CRITICAL THINKING AND ANALYSIS 1. What is the relationship between uniformity (both finite and rigid) and disclosure? This is more a case of complementarity than anything else. Uniformity, in terms of employing finite where it is feasible and cost effective, and using rigid where it is not both require extensive disclosures to further bring about comparability. Finite uniformity may require more extensive disclosure than rigid as a means of explaining and justifying the event alternatives that have been taken. There is much disclosure that simply cannot be squeezed into the body of the financials segmental disclosure (SFAS No. 131), pension and OPRB information (SFAS Nos. 87 and 106), and disclosure of proven reserves in petroleum exploration (SFAS No. 69 and Chapter 15) are some examples worth noting. 2. Assume two countries adopt International Financial Reporting Standards (IFRS) for their financial accounting and reporting. One has a highly developed economic history; one has a language that has changed little over several hundred years and lacks today’s economic terms. How might comparability be affected if English IFRS is translated to the native languages of both countries? Student research should find multiple articles addressing the problems that language introduce to comparability across countries when adopting IFRS. Some articles they will likely find include: • Huerta, Esperanza, Yanira Petrides, and Gary P. Braun (April 2013). “Translation of IFRS: Language as a barrier to comparability,” Research in Accounting Regulation, 1–12. • Nobes, Christopher (2013). “The continued survival of international differences under IFRS,” Accounting & Business Research, 83-111. The myth that IFRS adoption immediately creates comparability across countries raises the question regarding a single set of standards for all countries. However, we have to start somewhere. 3. Morunga and Bradbury (2012) find that IFRS adoption may lead to some adverse disclosure results. Discuss their findings. Morunga, Maria and Michael Bradbury (2012). “The Impact of IFRS on Annual Report Length,” Australasian Accounting Business & Finance Journal, 47-62. The authors find that annual report length increased post IFRS adoption. The idea of information overload begs the question of “is this too much disclosure?” They suggest that narrative discussion in the annual report may be driven out by financials. Is this a favorable result of IFRS adoption? Chapter 10: International Accounting CHAPTER HIGHLIGHTS Chapter 10 examines the standard-setting process in other English-speaking countries, and the attempt to achieve international harmonization, convergence, or equivalence (whatever the term du jour is) of accounting standards. There are subtle differences between the terms, but in practice they are increasingly used as having similar meanings. The chapter covers several pre-IFRS approaches to accounting. Students may question why we consider pre-IFRS; this lays the foundation for why variance from strict IFRS may occur. After adopting IFRS, the countries’ historical accounting approaches may affect how IFRS may be interpreted and comparability across countries may be affected. The Anglo-Saxon (also called the Anglo-American) and the continental approaches to accounting reflect some marked cultural differences within Western civilization. The Anglo- Saxon approach is grounded in strong equity capital markets and a strong accounting profession with accounting rule making usually centered in a quasi-private organization. For continental countries debt financing through major banks has been far more important than the use of equity capital though this is beginning to undergo change. In addition, the accounting profession has not been especially strong in continental countries and accounting rules have been determined by law. The formation of the European Union (EU) brought changes to this picture, first by the issuance of several directives that attempted to bring about harmonization of accounting to EU members. However, in 2005 all countries within the EU began using International Accounting Standards Board (IASB) standards for consolidated financial statements. EU standards are also allowed for financial reporting on the New York Stock Exchange without the need for reconciling to United States GAAP. The latter has come about as a result of an attempt to bring about “convergence,” a moving together between IASB standards and U.S. GAAP. This EU adoption gave legitimacy to the IASB as a global standards setter; it is now on equal ground with the FASB. For years, the U.S. was relatively passive about international standards with little need to go beyond U.S. GAAP. Without a doubt, U.S. GAAP provided the most developed and most broad set of standards in the world for the last century. However, the corporate accounting and auditing scandals left everyone reeling in the early 2000s. Hence, following directives from the SEC and Congress, the FASB’s newfound interest in convergence with IFRS blossomed. The IASB-FASB convergence projects started with the Norwalk Agreement of 2002 and are reaffirmed in the annual Memorandum of Understanding. The projects are both short-term and long-term in nature. The short-term projects are intended to remove numerous individual differences in standards between IFRS and US GAAP. The long-term projects include those areas where accounting guidance will be improved (e.g., share-based payments, revenue recognition). In 2004 the two bodies added a conceptual framework project to their joint work. They have completed work on the objectives and qualitative characteristic (item 1) and are pursuing convergence on (2) elements, recognition and de-recognition, and (3) measurements. Projects not yet started include: (4) reporting entity, (5) presentation and disclosure, (6) purpose and status, (7) applicability to not-for-profits, and (8) finalization of the complete framework. We recommend that you review the IASB’s most current work plan online before starting this chapter. The changes are occurring significantly faster than any textbook can keep up with given its publication cycle. Note: There is a short project at the end of this file that you may want to use in your course. We have found that it is best assigned to small student groups, 2-3 members per group. Once the papers are submitted, group presentations to the class complete the projects. QUESTIONS Q-1 What does harmonization of accounting standards mean? Harmonization concerns the degree of similarity or uniformity among the various sets of national accounting standards and methods of financial reporting. Q-2 What is convergence and how does it differ from harmonization? Convergence arose as a result of an effort to eliminate major differences between IASB standards and U.S. GAAP. The reasons for the convergence projects vary, but a generally accepted one is an effort to improve financial reporting efficiency. Convergence of the two standards would allow for American security registrations and for published financial statement purposes without reconciliation between the two. The term “equivalence” has also been used when referencing convergence projects. Convergence projects are underway between the IASB, the USA, and Japan. However, as of 2011, the Japanese convergence project is moving significantly slower than the one with the USA. The Norwalk Agreement of 2002 and the separate conceptual framework project of 2004 are moving forward, showing good progress towards convergence. U.S. laws now require annual reporting by the SEC, FASB, and PCAOB on improving financial reporting (e.g., principles-based accounting, transparency, understandable standards), so continued progress towards convergence of IASB and U.S. GAAP is probable, albeit slower than what we would like to see. The IASB usually takes about five years to publish a new standard, so this is definitely a long-term project. Harmonization is more passive and involves a general movement among “first world” countries. One aspect of harmonization, material harmonization, refers to making the accounting practices of different enterprises similar. Note that recent articles in the popular press tend to use the terms harmonization, convergence, and equivalence as meaning the same thing. The key thing to look fro in the U.S. once convergence is attained will be “adoption.” Q-3 The EU opted to use exclusively IASB standards for consolidated financial statements beginning in 2005. What drove this decision? While the Fourth and Seventh Directives improved harmonization, the pace was not fast enough, particularly since many firms needed access to major capital equity sources. As a result, the IASB’s body of accounting standards allowed for a significantly faster harmonization of financial reporting within the EU nations. In 2005, 7,000 listed EU companies began reporting using IFRSs, creating a significant workload for the IASB. Q-4 Compare the true and fair view of the United Kingdom, the “present fairly” outlook of the United States, and the legalistic view of the Continental model. The “true and fair” view is grounded in “economic reality” and refers to using judgment in order to make financial statements more useful for decision-making purposes. This may well mean going around existing standards. The “present fairly” outlook has been seen as somewhat similar to the true and fair view, but generally means that financial statements are presented in accordance with GAAP. Superficially, then, the present fairly outlook seems to correspond with the legalistic view of the continental model, except that United States GAAP is much more user- oriented than the continental model, which is geared more toward protecting creditors and determining income tax liabilities. Q-5 What are the different conceptions of the true and fair view? The true and fair view, which is an abstract concept to begin with, appears to be subject to individual interpretation within each of the EU nations according to their own needs. Note that this term has drawn particularly strong responses from the UK accounting profession. The IASB-FASB convergence project on a conceptual framework evoked strong words regarding what the UK views on this term really mean. Note that translation of the words “true and fair” to a non-English language is problematic, especially when the culture lacks a strong economic language. Q-6 Why has no Continental model country developed a conceptual framework? The primary purposes of the continental model—at least prior to the EU directives, which are geared to the true and fair view though done within the cultural restraints of each member country—have been to protect creditors and to determine tax liability. These relatively narrow objectives do not really need a broad theoretical document such as a conceptual framework for developing accounting standards. Even more to the point, continental model countries do not have standard-setting organizations such as the FASB. Conceptual frameworks would hardly be used where company law alone is the primary instrument for making accounting rules. Q-7 What is the relationship between the IFAC and IASB? IFAC (International Federation of Accountants) and IASB (International Accounting Standards Board) are complementary and work in different spheres, but they cooperate with each other. IASB’s primary function is the harmonization of accounting standards, which they attempt to achieve by issuing international accounting standards. IFAC issues guidelines in areas such as auditing standards, education, and ethics. A good class discussion question might address why these two organizations should or should not consider merging at some point in the future. Q-8 What are the main distinctions between the Anglo-Saxon and the continental models? Anglo-Saxon countries are more user-oriented and less oriented toward the primary purposes of protecting creditors and determining income tax liability. Anglo-Saxon countries have stronger accounting professions than do the continental countries. They are also more likely to have standard-setting agencies and conceptual frameworks, though these are much more recent developments. Q-9 How does the role of government differ in the United Kingdom and the United States relative to financial reporting? Standard setting in the United States is accomplished through private sector bodies; today the FASB is that body. The SEC has statutory authority to set accounting standards, but has relegated that to the FASB. It is important that the FASB receives its funding from the SEC approval of its budget. The FASB’s funding comes from accounting support fees, not taxpayer monies. However, the collected fees are funneled through the SEC for its approval of the FASB’s annual budget. There is no United Kingdom equivalent of the SEC. The main standard-setting thrust in the United Kingdom has come through the company laws in the past. In addition, there have been some government-sponsored committees that have made recommendations in the United Kingdom in areas such as inflation accounting, but these committees have included members from the profession. The United Kingdom has been moving closer to the American model of standard setting since 1970. Q-10 What are the possible implications if accountants outsource the balance sheet to external appraisers (applying fair value accounting) for period-end financial statement reporting? This is a thought question. Might the internal accounting function be relegated to simply bookkeeping with periodic receiving of finished parts from external vendors for assembly into a finished financial report. Discuss whether accounting as a manufacturing entity, producing financial reports, might benefit or be adversely affected by this type outsourcing. Might we learn from the automotive industry? Might the audit be shifted from individual companies to the suppliers (appraisers) supplying the fair values for balance sheet preparation. This would be a paradigm shift that the accounting profession would resist and likely not see coming (consistent with Kuhn’s view of paradigm changes). Q-11 For years the FASB had little interest in pursuing international harmonization projects. What prompted its seemingly new interest in 2002 to work with the IASB in such a cooperative manner? Remarks by Paul A. Volcker before the Accounting Regulatory Committee of the European Commission, Brussels, 25 Feb 2005. Paul Volcker, former Chair of the International Accounting Standards Committee Foundation (IASCF) says that international standards were fine for years, “so long as they were made in the good old U.S. of A” It was the series of accounting and auditing frauds that created the more receptive attitude towards international standards. The U.S. model of financial reporting was obviously not working. Add some very specific changes in the law (SOX of 2002) requiring the SEC to act and the idea of working with the IASB became significantly more attractive than in the past. Q-12 Evaluate the IASB’s approach to convergence. The IASB sees development of a single set of high quality, global accounting standards to help users make economic decisions as its objective. It assumes that if attained: (1) financial reporting costs will be reduced, (2) comparability will be enhanced, (3) investment risk will be reduced and, therefore, lower the cost of capital, (4) international capital flows will be improved, and (5) financial returns will improve. Approximately 50% of the world’s market capitalization is in the U.S. and there are only two major standard-setting bodies, IFRSs and U.S. GAAP. So, the IASB’s plan to converge with U.S. GAAP, its only viable competitor, makes sense to us. IRFRs (as of 2007) are used in over 100 countries for listed companies and over 60 countries for unlisted companies. By converging with U.S. GAAP, it enhances its credibility with the remainder of the non-IFRS world. It also improves the possibility that the U.S. will eventually adopt IFRSs. The challenge/risk with convergence is that differing standards will be negotiated to reduce variances. The result could affect the high quality objective. Special interests could overrule the need for transparent reporting. Finally, once convergence is stated as being achieved, consistency of implementation (especially when translating the English standard) is a concern that will need to be addressed. Otherwise, you may think you have comparability when none exists. Q-13 As Schipper seets it, why do the rules based and principles based approaches to standard setting tend to converge? Schipper, Katherine (2005). “The Introduction of International Accounting Standards in Europe: Implications for International Convergence, “European Accounting Review” (May, 2005), pp. 101-126. Schipper believes that a principles-based approach needs extensive implementational guidance to make it work well. This will result in an erosion of the differences between rules-based and principles-based approaches. Without the implementational guidance, preparers and auditors will revert to other sources for guidance (e.g., local jurisdiction-specific GAAP, EITF pronouncements), reducing comparability. So, as convergence progresses between U.S. GAAP and IFRS, expect IFRS to look more like rules-based standards. Q-14 How will the role of national standard-setting bodies be affected by adoption of IASB standards? This is a thought provoking question, one with no single correct response. One extreme would be to assume that adoption of IASB standards would negate the need for any local (country) standard-setting body. Politically, this is not likely. New Zealand is a good example of what has occurred when this change took place. We suggest that if (probably when) the U.S. adopts IASB standards, the FASB will remain as a standards-setting body, but with a revised role. That role may be one of advisory to the IASB or it may morph to a standards setter for private companies. For decades the U.S. has led the world with its accounting standards. This leadership culture will resist relinquishing that role. However, if another round of accounting scandals emerges, we believe IASB adoption is likely. Q-15 How do de facto harmonization and de jure harmonization differ from each other? De facto harmonization (also called material harmonization) refers to harmonization of the financial reporting practices. De jure harmonization (also called formal harmonization) refers to of harmonization of the accounting rules or regulations of different countries or groups. So, the difference relates to the rules themselves versus how they are implemented. Harmonization is, therefore, a moving target and measurement of the degree of harmonization is problematic. Q-16 What are the advantages of convergence-harmonization of accounting standards? Financial reporting costs will be reduced. Comparability of financial reports will be enhanced. Investment risk will be reduced and, therefore, lower the cost of capital. International capital flows will be improved. Financial returns will increase. Note that the idea of convergence is not 100% accepted by all as the way to go; ask your students to search for the positions of the larger CPA firms. Q-17 Is the revenue-expense orientation consistent with fair value measurement? Benston, George, M. Bromwich, and A. Wagenhofer (2006). “Principles-Versus Rules-Based Accounting Standards: The FASB’s Standard Setting Strategy,” Abacus (Vol. 42, No. 2), pp. 165-188. BB&W suggest that the principles-based approach would work better in tandem with the revenue-expense orientation rather than the asset-liability of SFAC No. 6. Their reason for this view is that with fair value accounting increasingly coming on board, accounting standard setters would have an extremely complex mechanism with many rules and guidelines (this point is true relative to SFAS No. 157). They see the revenue-expense model as being able to produce more reliable and auditable numbers. However, there is an inconsistency between the revenue-expense approach and fair value measurement because fair value is primarily geared to the primacy of the balance sheet. BB&W would provide under either principles-based or rules-based standards, a true-and-fair override which would give accountants more professional responsibility and provide more transparent numbers. CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1. What are the main distinctions between the Anglo-Saxon and the Continental models relative to accounting and financial reporting? Within the Anglo-Saxon group, how does the United States differ from other members of the group? What developments are leading to erosion of differences between at least some members of the Anglo- Saxon and Continental groups? The Anglo-American model is more strongly oriented toward providing financial information for users (mainly investors and creditors), whereas the continental group is more oriented toward protecting creditors and providing tax information. The accounting profession is much stronger in Anglo-American countries as opposed to continental countries, whereas governmental influence is stronger in the latter. Within the Anglo-American group, the United States’ approach of a private-public partnership regarding standard setting is unique. However, most countries in this group now have standard- setting organizations that diminish, to some extent, the dominance of company laws in the standard-setting arena. Also like the United States, the United Kingdom, Canada, and Australia have now developed conceptual frameworks, although these newer conceptual frameworks have a slightly broader purpose—accountability—as opposed to primarily being geared to user (investor and creditor) needs. Organizations similar to the Emerging Issues Task Force are arising in Anglo-American countries. The great leveler between the Anglo-American and continental groups is that the European Union consists of countries in both groups. Hence, differences within the EU were slowly beginning to crumble in light of the Fourth and Seventh Directives, which favor the true and fair view. Nations, however, could implement these directives within their own cultural orientation, at least to a limited extent. The requirement that all EU countries must use IASB standards for consolidated financial statements will – in a short time – tear down the wall between the two groups. 2. According to Alexander and Archer (2000), Anglo-Saxon (or Anglo-American) accounting is a “myth.” Discuss their reasons for this. Do you agree with them? Alexander, David, and S. Archer (2000). “On the Myth of ‘Anglo-Saxon’ Financial Accounting,” The International Journal of Accounting (Vol. 35, No. 4), pp. 539–557. Alexander and Archer analyze "true and fair view" and "fair presentation in accordance with GAAP" showing that a difference exists between the UK and US approaches. The differences between UK and US financial reporting are taking on an increased significance that is evident in recent articles resulting from the IASB-FASB convergence projects. Increased SEC oversight of the FASB suggests that the FASB as an Anglo-Saxon model member is changing, making the term one for historical reference only. CRITICAL THINKING AND ANALYSIS 1. Why do we need international accounting standards? Why not simply let each country develop and use its own standards and let it go at that? With increasing registration of foreign securities listings on domestic stock exchanges, securities exchanges very likely want as much harmonization as possible whether it comes through IASB standards or standards of the various nations. Securities exchanges such as the New York Stock Exchange would also want harmonized standards which might be termed as “high quality” standards. From the standpoint of regional associations such as the European Union (and possibly NAFTA, somewhere down the line) this may prove to be a boon because it is going to be very difficult to attain harmonization within their grouping where national legislatures within continental model countries retain so much power. A supranational organization such as IASB may be quite helpful in terms of bringing about harmonization. Note, however, that the IASB has no authority to force adoption of its standards. The role of standard-setting agencies in Anglo-Saxon model countries, such as the FASB, is most ambiguous. With the IASB playing a dominating role in harmonization, country-specific standard-setters appear to be relinquishing power to the IASB. However, the politics behind the scenes is an unknown at this point, a very intriguing topic. Another possibility involves a possible two tiered approach with national standards by the FASB and other standard-setters exceeding minimum level standards of the IASB is another possibility. How much freedom domestic firms would have to choose IASB standards over their own national standards becomes an interesting question. 2. The IASB and FASB are pursuing a single, converged conceptual framework. The United States has a good start with SFAC No. 8. What additional changes should FASB make to further improve its conceptual framework? This is an appropriate in-class, small group discussion assignment. Have the students review the respective conceptual frameworks before class. The qualitative characteristics are converged, so what needs to be done next? There is not a correct answer, but the process highlights the difficulty in developing a single framework. Emphasize that the FASB framework is for standard-setters; the IASB’s is for standard-setters and practice. When faced with an unclear accounting problem, IFRSs practice first looks for comparable existing standards and then relies on the conceptual framework for guidance. FASB’s framework has no such authoritative nature. 3. In 2003, South Africa was the first country to adopt IFRS with fair value accounting. The country does not allow for differential accounting treatment depending on the size of enterprise. What type of response do you expect from this implementation? Many of the country’s small farmers were outstanding vintners, but not accountants. Principles- based IFRS was overly complex with relatively few guidelines for implementation. Language and culture were obstacles that produced stress from the accounting, not from the production of their grapes. Note: A small project, one not listed in the text book, for the semester that you may want to consider follows: Objective of the project Obtain an understanding of U.S. GAAP, IFRS, and GAAP as practiced by a third accounting body (e.g., Canada, China, India, Mexico, Russia, Taiwan, Vietnam). This triangular review of these systems should identify the commonalities and analyze the differences between the three accounting systems. Small Group Collaboration This assignment will completed by student teams of 2-3 students per team, a size of three members being ideal. FASB and IASB GAAPs will be relatively easy to identify and analyze. The third country’s GAAP may be difficult to locate and translate, so invest some time reviewing individual country GAAPs before locking in your selection. Outline of the Paper Introduction: Tell me what you are going to tell me. Specific country • Description of country (e.g., demographics, language, economics). • Description of its accounting standards setting body, equivalent of the FASB and IASB. Include its history, board composition, processes, structure, whatever is necessary to understand its processes used to create GAAP. Make sure you research your country on the Internet to determine if the standards-related information is in a language you can understand. Do this before telling your teacher which country you want to study. • Country’s accounting standards, define its GAAP. Couch the description in the context of the type model it tends to follow (e.g., Continental, Anglo-Saxon). This could become lengthy, so talk with your teacher, if it appears to be overwhelming. Comparisons • Prepare a table that compares the three GAAPs. To facilitate comparability within the class, format your table as follows: o Column 1, IASB standard o Column 2, FASB standard o Column 3, your specific country’s GAAP o Column 4, your qualitative assessment of the variance between the three GAAPs. 0. insignificant or no differences between the bodies 1. minor differences between the bodies 2. significant difference between two of the bodies 3. significant difference between all three bodies Note that IASB has some 41 standards (some may have been superceded); this is too many to address in your research. Instead, focus on 10-12 at most. • Analysis o Analyze those standards you have assigned a number three (3) in column 4 above, a maximum of five (5) standards. If you have less than five number 3s, add number 2s to your potential analysis list until you have a minimum of seven (7) standards to analyze. o In your analysis, determine the theoretical basis (the rationale) for each of the respective GAAPs. • Convergence o Present your proposal to harmonize/attain convergence of each standard (again, focus on the five standards you identified as having the most significant differences). o Describe the largest obstacles to attaining convergence of each standard, immediately following your proposal for each one. o Which, if any, of your country’s GAAPs are possible solutions for IASB and FASB differences? Summary • What are your conclusions from your study? • Tell me what you told me. Style Requirements Submit your assignment electronically to Professor Dodd before the beginning of the class on 22 March. • Microsoft Word document • 12-point font • Use the header and footer in this document • Single-spaced body of the text • Double-spaced between paragraphs • Beginning of paragraphs is not indented • Bibliography (references) is last page of your paper • Parenthetically cite your references (e.g., Wolk, 1996) Example of the Comparisons section of your country-specific project India This is just a very brief comment to introduce you to the example country that follows. The Institute of Chartered Accountants of India (ICAI) is the governing professional body representing the accountancy profession at national and international levels. The Accounting Standards Board of the ICAI issues statements of Accounting Standards (AS) prescribing methods of accounting approved for application to financial statements. In addition to the AS, the ICAI issues generally accepted accounting principles (GAAP), and guidance notes that must be followed. Comparisons Prepare a table similar to the following one. Note that I added endnotes to clarify why I classified the variance as a “1, minor differences in the bodies” in this single example. The instructions do not require that you footnote/explain every number in your Variance column, but you may find it helpful as you analyze each standard. I used IAS 7, Cash Flow Statements, as an example of how to approach the assignment. IFRSi FASB Indiaii Varianceiii IAS 1 Presentation of Financial Statements IAS 2 Inventories IAS 3 Consolidated Financial Statements superceded by IAS 27 and 28 IAS 4 Depreciation Accounting replaced by IAS 16, 22, and 38 IAS 5 Information to Be Disclosed in Financial Statements IAS 6 Accounting Responses to Changing Prices Superseded by IAS 15, which was withdrawn December 2003 IAS 7 Cash Flow Statements SFAS 95 Statement of Cash Flows AS 3, revised 1997 Cash Flow Statements 1iv etc. through IAS 41 IFRS 1 through 8 Note that the instructions require that you start with the IASB standards. This will be the limiting factor in your analyses (41 IASs + 8 IFRSs). Note that some of the IFRSs have been withdrawn and will require no comparisons or analysis; some may have no comparables at FASB or within your country. Once you have completed the table, go to the next step and analyze those with variances rated as threes, significant difference between all three bodies, but limit your analysis to only five standards. This will meet the requirements for this part of the assignment. However, if you actually get interested in this assignment, you may want to go beyond this step and identify differences that this methodology misses. Remember that the objective of the assignment is to obtain an understanding of the similarities and differences between the accounting standards of IASB, FASB, and a set of country-specific standards. It requires detailed work that can become frustrating. So, remember that patience is definitely a virtue. i The term 'IFRSs'. The term International Financial Reporting Standards (IFRSs) has both a narrow and a broad meaning. Narrowly, IFRSs refers to the new numbered series of pronouncements that the IASB is issuing, as distinct from the International Accounting Standards (IASs) series issued by its predecessor. More broadly, IFRSs refers to the entire body of IASB pronouncements, including standards and interpretations approved by the IASB and IASs and SIC interpretations approved by the predecessor International Accounting Standards Committee. Reference: Deloitte URL: http://www.iasplus.com/standard/standard.htm ii It may be helpful to add an appendix (for reference only) with the more detailed explanations of each standard India uses. ICAI URL: http://www.icai.org/icairoot/resources/as_index.jsp iii Qualitative assessment of the variance between the three GAAPs 0. insignificant or no differences between the bodies 1. minor differences between the bodies 2. significant difference between two of the bodies 3. significant difference between all three bodies iv India requires that cash flows arising from interest paid and interest and dividends received in the case of a financial enterprise be classified as cash flows arising from operating activities. In the case of other enterprises, cash flows arising from interest paid are classified as financing activities. IASB allows for interest classification as an operating or financing activity. FASB requires that it be within the operating activities section. CHAPTER HIGHLIGHTS This chapter starts by examining the philosophical relationship between the balance sheet and income statement. Two separate issues emerge: articulation between the two and which one is to dominate, assuming articulation (asset-liability or revenue-expense approach). These choices are pure cases but they do illustrate the broad theoretical choices that exist. The changes in element definitions (assets, liabilities, and owners’ equity) are detailed from the Accounting Terminology Bulletins, to APB Statement No. 4, to SFAC Nos. 3 and 6. The important point is that there is a marked reorientation to the asset-liability perspective in APB Statement No. 4 and the conceptual framework project, away from the revenue-expense perspective of the Accounting Terminology Bulletins. The chapter moves to an overview of recognition and measurement practices with respect to major types of assets and liabilities, as well as components of owners’ equity. The general rule of recognition is that assets and liabilities are recorded on the basis of events in which resources (assets) are acquired or obligations (liabilities) incurred. Assets and liabilities are generally measured at the exchange prices established in the transactions. However, subsequent values of accounts become much more varied, especially for assets. Receivables approximate net realizable value because of the allowance for uncollectible accounts. Depreciable (or amortizable) assets, inventories, and investments subject to equity accounting (APB Opinion No. 18) are all examples of arbitrary accounting book values in which the assets represent unique accounting attributes rather than any market referent (either entry or exit prices). From a pure measurement theory point of view, these varied and diverse accounting calculations/measurements are not additive. This does not mean that the balance sheet is uninformative, but it does legitimately raise the issue of whether or not ratio analysis on the components of the balance sheet is meaningful. The chapter contains extensive discussions on investments in marketable securities (SFAS No. 115), impaired assets (SFAS No. 121), and financial instruments with emphasis on derivatives. The chapter concludes with a discussion of classification within the balance sheet. The convention is based on liquidity, but, as pointed out in the text, liquidity is perhaps better captured in the cash flow statement. Alternative classification schemas are suggested relating to how the assets are utilized, or to the nature of the liability (contractual, constructive, equitable, contingent, and deferred charges). Finally, one could group assets and liabilities by the basis of measurement or accounting calculation in order to achieve a more systematic basis of classification. QUESTIONS Q-1 What are the characteristics of assets, liabilities, and owners’ equity, and how have they evolved over time? Assets have evolved from narrow definitions based on legal property to a broader concept based on economic resources. Liabilities have evolved in a similar manner. Owners’ equity is usually Chapter 11: Balance Sheet treated as a residual (the net of assets minus liabilities), subject to legal capital requirements to comply with state laws of incorporation. This is a proprietary approach. Q-2 Why is it difficult to define the basic accounting elements? In order to unambiguously define elements, the definitions would need to be very narrow, probably based on legal concepts. This produces a very narrow balance sheet. Broader definitions, while potentially more relevant, are also ambiguous. There seems to be a tradeoff between reliability and relevance, even at the basic definitional level. Q-3 Why are asset and liability definitions important to the theoretical structure of accounting? Why are definitions important to policy setting bodies? At the most basic level, element definitions represent the accounting classification system. They determine (partially at least) what is to be recognized and how it is to be classified. Given the inexact nature of accounting as a science, the definitions by themselves are insufficient. Accounting relies heavily on a pragmatic, secondary series of rules to complete the recognition process. Q-4 Numerous attributes are measured in the balance sheet. What are the different attributes? Why is this practice criticized? Some attributes would be replacement cost provided it is lower than historical cost (inventories) replacement cost (fair value) for trading and available-for-sale securities; net realizable value in the case of accounts and notes receivable, though this is undoubtedly above the amount at which they could be sold or factored; and unamortized historical cost in the case of depreciable and amortizable assets, though this term, in turn, might be subject to several interpretations based on the method of amortization used. Cash is multi-dimensional in nature. Liabilities are generally valued at net realizable value (the amount at which they can be disposed). Bonds payable are an exception. Unamortized cost applies if straight-line amortization of premium or discount is used. If “scientific amortization” is used, it is valued at present value using a historical cost rate, however. Owners’ equity is a residual, but elements here are often affected by statute. Valuation is, hence, very much of a “mixed bag.” Additivity, as well as relevance, is certainly open to question. This question should generate considerable class discussion and may also be quite eye-opening. Q-5 What do aggregated balance sheet totals represent? These balance sheet data are used for ratio analysis. How useful do you think ratio analysis is? The answer to this question is really an extension of question four above. The question of the lack of additivity and relevance is obviously at issue here which can severely impact ratio analysis. Good financial analysis recognizes this potential problem and invests in adjustments to evaluate a firm’s economic value. Q-6 Multiple approaches have been advocated concerning the definition of accounting elements and the relationship between the balance sheet and income statement. What are these approaches and how do they differ? The basic distinction is between two approaches: articulated and not articulated. Within the articulated approach, the question is which statement is to be primary, and which is to be derivative (the asset-liability and revenue-expense approaches, respectively). Q-7 What is the meaning of “owners’ equity” in the balance sheet? Why are certain unrealized gai or losses included in owners’ equity? Traditionally, owners’ equity is seen as the residual of net assets after fulfilling obligations to creditors. A proprietary approach has been taken in its presentation. Inclusion of unrealized gains/losses relates directly to articulation between the balance sheet and income statement. These items represent postponed income statement items, and produces a kind of non- articulation. The items are restricted to gains/losses on foreign operation translation (SFAS No. 52) as well as available-for-sale securities (SFAS No. 115). Q-8 What are deferred charges and deferred credits, how do they come about, and do they conform to asset and liability definitions? Deferred charges/credits are debits/credits that are postponed in the income statement through balance sheet recognition. These debits/credits are clearly neither assets nor liabilities (except in limited instances), yet have been forced into these balance sheet categories by default. Of course, they come about because of a revenue-expense orientation, that is, primacy of income statement recognition rules. Q-9 Why have mutually unperformed executory contracts traditionally been excluded from financial statements? Can this practice be justified in terms of asset and liability definitions? How relevant is this approach for professional sports franchises? Mutually unperformed executor contracts traditionally been excluded from financial statements since there is an implied offset of the unrecorded asset and liability. Another way to explain it is that neither party is obligated because both have unfulfilled (and offsetting) future obligations. There is a contractual benefit and promise, even though unexecuted. Recognition has been prohibited on the more practical grounds of uncertainty or measurement problems. For an operation such as a sports franchise, virtually all economic “assets” and “liabilities” are related to employment contracts (which are mutually unperformed). In terms of relevance, a case can be made for recognizing these contracts. Another issue is whether executory items should be used in the determination of current expense numbers as in the case of pensions. Q-10 What is the purpose of balance sheet classification? How useful is the information produced from a classified balance sheet? What are some alternative classification systems that could be used? Classification could proceed along several lines: by attribute being measured, by liquidity, by way in which realization will occur. In effect, all of these represent partial disaggregation of totals. In terms of pure measurement theory, total aggregation is dubious because of the individual accounts not being additive. However, movement towards fair value accounting will reduce this problem. Q-11 As a potential investor, what do you feel would be the most useful attribute of measurement for each of the following: inventories held for sale, inventories held for production, and long term debt? Would your answer differ if you were a potential lender? What if you were a manager of a company? What measurement problems are illustrated by this question? At issue here is the possibility that alternative measurements are useful to different types of users. This ties in to the user heterogeneity problem. Inventories held for sale might be most relevantly reported at exit prices for investors and creditors, and both exit price and replacement cost for managers. Inventories held for production might be reported at replacement cost for investors and managers, and exit price for creditors. Long-term debt might be reported at book value for creditors, and present value for investors and managers. Multi-attribute reporting is one possible means of improving the information content of the balance sheet, but at a cost of adding complexity to the reporting process. Q-12 Why is it difficult to determine the historical acquisition cost of self constructed assets? Do definitions of accounting elements and general principles of recognition and measurement resolve the controversy over full absorption costing and variable costing of manufactured inventory? The issue is what is appropriately charged to asset cost, particularly in the absence of an arm’s length transaction. Even more ambiguous is the allocation of overhead costs to self-constructed assets. Element definitions do not help in resolving this measurement problem. Q-13 The limitation of the accounting classification system depicted in Exhibit 11-1 was referred to throughout the chapter. What is meant by this? Give some examples. Why is the accounting classification system the foundation of the accounting discipline? With broad, ambiguous element definitions, there is the potential for dissimilarity among the elements. This was emphasized in the text for both assets and liabilities. Disaggregation is one way of dealing with this problem. It is an important issue because classification is the foundation for any science. Q-14 Is the “available for sale” category for debt and equity securities used in SFAS No. 115 a homogeneous category? Distinctions between available-for-sale securities and the other two categories are fairly loose. As noted in the text, transfers between available-for-sale and trading securities should be relatively easy. Available-for-sale categories are not very clearly defined: they are simply everything not in the other two categories. Furthermore, selection among categories is based upon management intent, which leaves the door open for potential management/manipulation. Q-15 Based on your reading of this chapter, plus your general knowledge of accounting standards, identify five examples of measurement flexibility in the statement of financial position. Some examples are depreciation, inventory, treasury stock, conversion of convertible debt, full cost/successful efforts for oil and gas companies, and stock dividends between 20 and 25 percent. An interesting question to pose is whether rigid uniformity would affect manager-owner wealth, and what the net social benefit or cost would be. It could be argued that there would be a net benefit at the social level, due to simplification and lower accounting costs, while at the individual level, the redistributive (wealth) effects would net to zero. Q-16 SFAS No. 133 (213 pages), 149 (78 pages), and 155 (27 pages) define standards for derivatives in 318 pages. How would a principles-based approach to setting standards affect their length…or would it have any effect? Rules-based standards are necessarily lengthy. Introduction of a rule makes implementation of the standard easier in practice, but makes the standards read more like legal briefs than guidance expressing the spirit of the standards. The trade-off is that professional judgment must be relied upon more when using principles-based accounting to set the standards. Q-17 Discuss the bright line that does or does not distinguish debt and equity classifications. The distinction (bright line) between debt and equity is very fuzzy Convertible bonds have aspects of both debt and equity and are included in earnings-per-share calculations. Redeemable preferred stock has attempted to enter into this hazy area, even though it appears to actually be debt. Q-18 Why is there an implicit recognition of fair value in the 1984 Revised Model Business Corporation Act? The 1984 Revised Model Business Corporation Act allows dividends to be paid as long as insolvency is avoided, one of the criteria of which is that fair value of liabilities exceeds fair value of assets. Hence, as in the case of Holiday Inn, which declared a dividend exceeding owners’ equity, implicit recognition of fair values occurs. Q-19 How does the asset impairment measurement approach of SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, compare to deprival value? Deprival value is a more broad-gauged measure because it aims to determine value in use. By taking the higher of present value of future cash flows and net realizable value and comparing the “winner” with replacement cost and taking the lower of the two, a value in use measurement results which is not grounded in conservationism. Impairment is basically a “lower of” conservative type of calculation and nothing more. Also, future cash flows are not discounted. Q-20 Why are interest rate swaps a zero sum game? What one party gains, the other party loses netting out to a zero effect; this is referred to as a zero sum game. There is no incremental value created by the interest rate swap, merely a transfer of wealth between parties. Q-21 What is a securitization and why do firm’s use this technique? Assets such as mortgages receivable are “packaged” and sold to a transferee. The transferee finances the sale by issuing securities to another party. Assuming the transferor has relinquished all rights to the assets given up, the transferor has received funds without creating any debt which would occur if the transferor borrowed money using the assets as collateral. Q-22 Of the various reasons that a firm might deal in its treasury stock, are there any that you might think are questionable? Discuss. Of the various reasons for dealing in treasury stock, supporting the market price of the firm’s stock is questionable because it raises the issue of whether stock price is being artificially increased. EPS management to meet analysts’ forecasts is suspect; is it symptomatic of more extensive accounting management/manipulation within the firm? Q-23 Are disclosures of hedging effectiveness effective? In interest rate swaps, the criteria for effectiveness appear to be too broad to zero in on effectiveness (the notional amount of the swap is equal to the asset or liability being hedged and the fair value of the swap is zero at its inception). Forward hedge contracts appear to provide better measures of effectiveness. Q-24 Why are convertible bonds and convertible preferred stock not examples of embedded derivatives? Convertible bonds and convertible preferred stock are not embedded derivatives because their values are tied to closely to that of main or host contract itself, that is the common stock to which these instruments are connected via the specific conversion ratios involved. Q-25 How does the term “embedded derivatives” compare with the term “embedded journalists” (from the Iraqi War)? Embedded derivatives are “embedded” in a “host” contract in a roughly similar way that journalists were “embedded” with military units. However, the secondary contract applying to the embedded derivative has no analogue relative to embedded journalists. This is a thought question, one with no clear correct response. However, the trend towards relevance over reliability suggests increasing reliance on professional judgment. Fair value accounting complements this trend very well. The challenge will be to determine processes to value intangibles with increased reliability. Q-26 Traditional measures of net assets do not capture the value of human capital in an organization. Which trends, if any, suggest that intellectual capital may eventually be a candidate for inclusion as an intangible on the balance sheet? This is a thought question, one with no clear correct response. However, the trend towards relevance over reliability (term under old qualitative characteristics) suggests increasing reliance on professional judgment. Fair value accounting complements this trend very well. The challenge will be to determine processes to value intangibles with increased faithful representation. The Nordic countries appear to be leading the way towards workable models. CASES, PROBLEMS, and WRITING ASSIGNMENTS 1. Review a recent annual report and consider the following: Identify all attributes of measurement explicitly identified in the balance sheet and accompanying notes. Notice which items are not specified. Group the accounting elements by attribute. How thorough is the explanation of measurement in the balance sheet? Identify any unusual assets or liabilities. How useful is the current noncurrent distinction for assessing liquidity? Based on your review, what level of user sophistication do you think is necessary to understand how the balance sheet numbers have been derived? How useful do you think the balance sheet is? What are its limitations and how might it be improved, especially from a communication viewpoint? This is an open-ended case designed to make students think about conceptual foundations of accounting measurement, as embodied in the output (balance sheet). Among the things to highlight are (1) the lack of detail concerning measurement and (2) the high level of aggregation. Ask students to discuss any unusual items they find. In terms of communication, it should be obvious that one needs to be an accountant to have even a basic knowledge of how an individual company accounts for itself. A useful discussion question to pose is the “reliability of efficient market research” in light of the sophistication required to understand financial reports. Intuitively, one is inclined to suspect that it might be possible to “fool” the market, particularly given investor preoccupation with bottom line information. Also, managers still seem to behave as if they believe this too. 2. Assume that an asset is being examined and it is determined that its cash flows would be $10,000 per year for four years (assume that all cash flows are received at the end of the year). The carrying value of the asset is $35,000 and its replacement cost is $30,000. The firm’s cost of capital is 10 percent. Required: (a)What would be the amount, if any, that should be written off because the asset is impaired under SFAS No. 121? (b)Why is your answer in part (a) anomalous and how does SFAS No. 121 justify it? (c)Would your answer to part (a) be different if the cash flows were $8,000 rather than $10,000? Explain. (d)Is there anything unusual about your answer to part (c) since accounting rules are frequently concerned with conservatism? (a) None, because the undiscounted cash flows exceed the carrying value of the asset. (b) The cash flows are undiscounted (reminiscent of troubled debt restructuring in SFAS No. 12) as well as carrying value also exceeding replacement cost (fair value). The standard takes the view that “cost recoverability” is the issue of real concern to management. This still flies in the face of the pervasiveness of present valuation. (c) Yes. The undiscounted cash flows total $32,000, which is less than the carrying value of the asset, so write-down occurs. The write-down will be $5,000 (down to the replacement cost of the asset). (d) The answer is anomalous for several reasons. First, replacement cost may well exceed the discounted value of the cash flows. Second, cash flows enter into the calculation of whether or not to write the asset down, but they are not part of the write-down measurement itself. 3. Assets A, B, and C comprise an asset group. Asset B is considered to be the principal asset in this group. Asset B has a three-year estimated life and A and C have remaining lives of four years. Data on the expected undiscounted cash flows of the three assets, their book values (carrying values), and their fair values less costs to dispose are shown below: 1 $18,000 $80,000 $12,000 2 15,000 70,000 10,000 3 12,000 65,000 9,000 4 10,000 6,000 Book value $60,000 $220,000 $20,000 Fair value less Disposal costs $65,000 $18,000 $25,000 Undiscounted cash flows by year A B C Required: (a)Determine the amount of impairment according to SFAS Nos. 121 and 144. (b)By how much should each of the assets be written down? (c)What theoretical problems do you see with the application of SFAS Nos. 121 and 144 to asset impairments? (a) and (b) Since Asset B is the principal asset in this group, it’s 3 year life governs. The 3 year undiscounted cash flow total $291,000 which is less than the book value of the three assets. Therefore, there is a $30,000 write-down (book value of $300,000 less fair value of $270,000). The impairment would be split on the basis of the proportionate book values: B would be 220/300 X $30,000- = $22,000, A would be 60/300 X $30,000 = $6,000 and C would be 20/300 X $30,000 = $2,000. (c) There are numerous theoretical problems. Cash flows are undiscounted in both standards. As in this problem, SFAS No. 144 may ignore cash flows of the secondary assets which occur after the end of the life of the principal asset in the group. The standards are “lower of” types of standards hence by definiti9on they are conservative and only involve write downs. 4. Assume an interest rate swap with a notional value of $1,000,000. Firm A receives fixed and pays variable. The fixed rate on December 31, 2000, is eight percent. The swap has two years to run with variable interest rates of 7.8 percent and 7.6 percent expected on December 31, 2001, and 2002, respectively (annual settlements are assumed for simplicity). Firm A’s discount rate is eight percent. Required: (a)Determine the fair value of the derivative and state whether it would be an asset or a liability. (b)Assume that the swap occurred prior to December 31, 2000, and the interest rate swap contract had a debit balance of $1,000. Under this circumstance make the entry for the fair value as of December 31, 2000. (a) At this point in time (Dec. 31, 2000), we would set up the following simplified table where the holder is receiving fixed and paying variable. “Received” by “Paid” by Net Firm A Firm A Received December 31, 2001 $8,000 $7,800 $ 400 December 31, 2002 8,000 7,600 200 $ 600 We discount these receivables at 8%, the fixed rate in effect on December 31, 2000: December 31, 2001 $400 × .92593 = 370 December 31, 2002 $200 × .85734 = 171 541 The variable rates in effect might also be used as the discount factor since the amount received is the difference between a fixed and a variable amount. Since the amount is to be received it would be set up as an asset. (b) Since $541 is the new debit balance which was $1,000 before we would debit Bonds Payable contra account for $459 ($1,000 – $541) and credit Interest Rate Swap contract for $459. The debit to Bonds Payable contra represents a decrease in valuation. Unrealized Holding Gain or Loss would be debited and credited for the $541 and represents unrealized holding gains and losses on the interest rate swap contract and the bonds payable which offset each other (we assume that the previous $1,000 unrealized holding gain and loss have been closed to comprehensive income). Accounting Theory (9th edition) 5. Shown below are paragraphs 8–10 of ARB 43, Chapter 7 on stock dividends. Para. 8. The question as to whether or not stock dividends are income has been extensively debated; the arguments pro and con are well known. The situation cannot be better summarized, however, than in the words approved by Mr. Justice Pitney in Eisner v. Macomber, 252 U.S. 189, wherein it was held that stock dividends are not income under the Sixteenth Amendment, as follows: “A stock dividend really takes nothing from the property of the corporation and adds nothing to the interests of the stockholders. Its property is not diminished and their interests are not increased . . . the proportional interest of each shareholder remains the same. The only change is in the evidence which represents that interest, the new shares and the original shares together representing the same proportional interests that the original shares represented before the issue of the new ones.” Para. 9. Since the shareholder’s interest in the corporation remains unchanged by the stock dividend or split up except as to the number of share units constituting such interest, the cost of the shares previously held should be allocated equitably to the total shares held after receipt of the stock dividend or split up. When any shares are later disposed of, a gain or loss should be determined on the basis of the adjusted cost per share. Para. 10. As has been previously stated, a stock dividend does not, in fact, give rise to any change whatsoever in either the corporation’s assets or its respective shareholders’ proportionate interests therein. However, it cannot fail to be recognized that, merely as a consequence of the expressed purpose of the transaction and its characterization as a dividend in related notices to shareholders and the public at large, many recipients of stock dividends look upon them as distributions of corporate earnings and usually in an amount equivalent to the fair value of the additional shares received. Furthermore, it is to be presumed that such views of recipients are materially strengthened in those instances, which are by far the most numerous, where the issuances are so small in comparison with the shares previously outstanding that they do not have any apparent effect upon the share market price and, consequently, the market value of the shares previously held remains substantially unchanged. The committee therefore believes that where these circumstances exist the corporation should in the public interest account for the transaction by transferring from earned surplus to the category of permanent capitalization (represented by the capital stock and capital surplus accounts) an amount equal to the fair value of the additional shares issued. Unless this is done, the amount of earnings which the shareholder may believe to have been distributed to him will be left, except to the extent otherwise dictated by legal requirements, in earned surplus subject to possible further similar stock issuances or cash distributions.1 Required: (a)From a logical standpoint, evaluate the CAP’s argument involving situations where market value of common stock should be capitalized in certain stock dividend situations. (b)Do you see a possible “hidden agenda” here involving certain economic consequences that the CAP was trying to bring about relative to stock dividends? 1 Reprinted by permission. (a) The CAP’s argument is quite convoluted. They appear to be saying that they (the CAP) understand that stock dividends are really not dividends but since recipients think that they are dividends, small stock dividends should be treated as if they really are dividends. If this isn’t bad enough, how would people really know that they are being treated as if they were really dividends. Short of reaching a point of ludicrousness, it would be difficult for a footnote to really convey this information. (b) There is clearly a hidden agenda here. At the time of passage virtually all dividends had to be paid out of earned surplus (retained earnings). Because shareholders do not know as much about the firm as management does, whether the stock dividend was really a “good news” signal may have been open to question. Therefore the CAP may have been trying to prevent small stock dividends by forcing a capitalization of earned surplus at market value if it exceeded par value. This might have put a strain on the source of future cash dividends. Whether this rule had any effect upon the declaration of any small stock dividend declarations is, in our opinion, highly doubtful. 6. Leeson Company entered into an interest rate swap with Morley Corporation on January 1, 2003. The notional amount of the swap is $20,000,000. Leeson will pay Morley a fixed annual rate of 8 percent. Morley will pay Leeson LIBOR plus 1 percent. Settlement is to be made every six months and the contract lasts for three years. The annual variable rates based on LIBOR plus 1 percent are: July 1, 2003 8.26% January 1, 2004 8.32% July 1, 2004 8.18% January 1, 2005 7.92% July 1, 2005 7.90% January 1, 2006 8.06% Required: (a)Set up a schedule showing the net receipts or payments for Leeson. (b)Why would Leeson enter into a strategy of this type? (c)Has Leeson benefited from this transaction? (d)What dangers are present? (a) Leeson's Fixed Rate LIBOR “Receipt” from Morley “Payment” to Morley Net Receipt or (Payment) Date Percent 01-Jul-03 8% 8.26% $826,000 $800,000 26,000 01-Jan-04 8% 8.32% 832,000 800,000 32,000 01-Jul-04 8% 8.18% 818,000 800,000 18,000 01-Jan-05 8% 7.92% 792,000 800,000 (8,000) 01-Jul-05 8% 7.90% 790,000 800,000 (10,000) 01-Jan-06 8% 8.06% 806,000 800,000 6,000 (b) By paying fixed interest and receiving variable rate interest, Leeson may well be hedging against rises in variable rate types of debt that they owe other parties. (c) Leeson has benefited in this transaction as a result of the rise in variable rates, which may well be offsetting variable rate borrowing from creditors. Thus, it appears that Leeson has hedged against a rise in variable interest rates. The danger is slipping from hedging into gambling. Thus, if Leeson puts an inordinate amount of money into swaps of this sort with the expectation that the variable interest rate will go up, and it goes down instead, the company could easily take a big loss. 7. On January 1, 2000, $1,000,000 of 10 percent debenture bonds were acquired by Means Corporation at $927,908, which would yield a 12 percent rate of return. The bonds mature on December 31, 2004. Interest is paid annually on December 31. Means Corporation classifies these securities as available for sale securities. Shown below are the effective interest rate and market value of the securities at various dates. Date Effective Interest Market Value December 31, 2000 11% $968,975 December 31, 2001 9% $1,025,310 December 31, 2002 12% $966,195 December 31, 2003 9% $1,009,173 Required: (a)Using the method suggested by Kathryn Means (i.e., use the current interest rate for the recognition of income and determination of fair value with the holding gain component going to owners’ equity), determine the income and unrealized holding gain components for the years 2000 through 2004 (assume that the interest rate change occurs on each December 31). (b)Make the entries that result from assuming that these debenture bonds were Means Corporation’s only available for sale securities. (a) Year Beginning of Year Yield Effective Interest Stated Interest Carrying Value Market Value Unrealized Gain Amortization (Loss) 2000 927,908 a 12% $111,349 $100,000 $11,349 939,257 b 968,975 c 29,718 2001 968,975 11% $106,587 100,000 $6,587 975,562 1,025,310 d 49,748 2002 1,025,310 9% $92,278 100,000 ($7,722) 1,017,588 966,195 e (51,393) 2003 966,195 12% $115,943 100,000 $15,943 982,138 1,009,173 f 27,035 2004 1,009,173 9% $90,826 100,000 ($9,174) 1,000,000 1,000,000 0 a($1,000,000 × .56743) + ($100,000 × 3.60478) b$927,908 + $11,349 (net investment at beginning of year plus or minus amortization) c($1,000,000 × .65873) + ($100,000 × 3.10245) d($1,000,000 × .77218) + ($100,000 × 2.5313) e($1,000,000 × .79719) + ($100,000 × 1.69005) f($1,100,000 × .91743) (b) see solution on next page DEBIT CREDIT 2000 Cash 100,000 Available-for-Sale Securities 11,349 Interest Income 111,349 Available-for-Sale Securities 29,718 Owners’ Equity—Unrealized Holding Gain/Loss 29,718 2001 Cash 100,000 Available-for-Sale Securities 6,587 Interest Income 106,587 Available-for-Sale Securities 49,748 Owners’ Equity—Unrealized Holding Gain/Loss 49,748 2002 Cash 100,000 Available-for-Sale Securities 7,722 Interest Income 92,278 Owners’ Equity— Unrealized Holding Gain/Loss 51,393 Available-for-Sale Securities 51,393 2003 Cash 100,000 Available-for-Sale Securities 15,943 Interest Income 115,943 Available-for-Sale Securities 27,035 Owners’ Equity—Unrealized Holding Gain/Loss 27,035 2004 Cash 100,000 Available-for-Sale Securities 9,174 Interest Income 90,826 Owners’ Equity— Unrealized Holding Gain/Loss 55,108 Realized Holding Gains Available for Sale Securities 55,108 The last entry in 2004 takes the sum of the unrealized holding gains/losses on available-for-sale securities and runs it through income. Holding these available-for-sale bonds to maturity would probably not occur frequently, but it illustrates Means’ approach adequately. Notice that the sum of the interest income and the holding gains equals $572,091, which is also equal to the cash dividends of $500,000 and the discount of $72,092 ($1,000,000 – $927,098). Available-for-sale securities are, of course, an example of non-articulation. CRITICAL THINKING AND ANALYSIS 1. It might be said that we are slowly moving toward an asset-liability approach in the balance sheet. Which event situations support this statement? Several indicators suggest a movement towards the asset-liability approach in U.S. standards including: • Income tax allocation has moved from revenue-expense in APB Opinion No. 11 to asset- liability in SFAS No. 109. • Pensions went from revenue-expense in APB Opinion No. 8 to asset-liability in SFAS No. 87. • Other postretirement benefits in SFAS No. 106 is largely asset-liability in orientation. • Finally, the FASB Response to the SEC Study on the Adoption of a Principles-Based Accounting System (July 2004) states that the FASB agrees with the SEC that the asset- liability view is most appropriate to setting financial accounting reporting standards. In a previous report the SEC had encouraged the FASB to maintain the asset-liability view in its movement towards objectives-oriented (the FASB interprets the terms “principles based” and “objectives-oriented” to be synonymous) standards setting. 2. In July 2003, the SEC submitted to Congress its Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System. A year later, FASB issued its reply, FASB Response to the SEC Study on the Adoption of a Principles-Based Accounting System (July 2004). The SEC recommended that FASB when setting standards “avoid the use of percentage tests (‘bright lines’) that allow financial engineers to achieve technical compliance with the standard while evading the intent of the standard.” Identify where bright lines currently exist in the statement of financial position, areas in which we might expect revisions in the future. What is the argument for use of bright-line tests? These two reports from the SEC and FASB are very interesting. You may want to have your students read both (the FASB one at a minimum) as part of this assignment. They clearly show expectations of institutional roles and show future directions for accounting standards. Movement from “bright-lines” and towards intent within standards again shows a leaning towards relevance rather than reliability. They also emphasize the spirit of accounting for a transaction rather than the ease of implementation by meeting a rule. The argument for bright- lines is primarily that it increases comparability, but the SEC study argues that this is only a false sense of comparability. Examples of bright lines include: common stock dividends, leases as capital versus operating expenditures, consolidation of SPEs, regular consolidations, and the corridor used for smoothing gains or losses on defined benefit pension plans. 3. The comingling of legal and contingent liabilities exists under current GAAP accounting. Discuss potential problems this creates and propose alternatives to address them. Legal liabilities are “certain” claims on the assets of the firm. Contingent liabilities may or may not be claims on the assets of the firm. Determining the amount of assets owed to outsiders becomes problematic when they are co-mingled. Financial ratios are then suspect. Chapter 12: Income Statement CHAPTER HIGHLIGHTS Chapter 12 is intended to be a comprehensive overview of the income statement. However, the focus is not on detailed issues; rather, fundamental questions of element definitions, recognition, and measurement are examined. The amount of time spent on Chapter 12 will depend on the background of the class and the instructor’s interests. At one level, considerable time could be spent reviewing each area covered, in effect recasting intermediate accounting topics in a more conceptual approach. Alternatively, the chapter could be examined more for broad generalities. For 50+ years the primary theoretical thrust to the measurement and recognition of income has been a revenue- expense approach rather than an asset-liability approach. More recently, however, the FASB appears to be changing that emphasis. Definitions of comprehensive income, revenues, and expenses contained in SFAC No. 6 clearly reflect that change. It probably will be several more years, however, before that change in emphasis will have an impact upon the income statement, because the statement is a product of 50 years of accounting standards based on the revenue-expense approach. Accounting theory regarding the recognition of revenue provides accounting practice some practical guidance in that it states that revenue should be recognized when the earning process is complete. Unfortunately, the completion of the earnings process frequently does not coincide with the time that objective measurements of the amount of revenue can be made. As a result, we find that revenue is recognized on the income statement at different times in different industries, even though the underlying circumstances surrounding the event giving rise to the revenue are identical or at least similar. The chapter points out several examples, such as revenue recognition when right of return exists and transfers of receivables with recourse, where inconsistencies exist today and why they were allowed to evolve. Future events is a very difficult area to maneuver through, and we are just starting to think about it systematically. Future events are, of course, related to future contingencies under finite uniformity. But we would still be facing the future events problem in rigid uniformity cases. If, for example, rigid uniformity were going to be used on an industry basis for depreciation accounting, issues of years-of-life and salvage values, both future events, would have to be faced. In general, accounting theory regarding expense recognition, i.e., matching, provides no practical guidance as to the timing or amount of expense to be recognized on the income statement. Basically, expenses should be recognized when the benefits from those expenses are received; however, it is difficult, if not impossible, to objectively determine how and when benefits are received. As a result, most expenses are recognized in accordance with a systematic and rational method of allocation. Accounting standards regarding the format of today’s income statement are reviewed in the chapter. Specific standards of the display of elements in the operating section do not exist; however, they do exist for the nonoperating section. Those standards or rules tend to be very strict and result in rigid uniformity as opposed to finite uniformity being the order of the day. For events classified as extraordinary and prior period (displayed in the retained earnings statement), there has been a definite shift in recent years away from finite uniformity to rigid uniformity, because of management abuses in order to accomplish income smoothing. In the specialized areas discussed stock options are of particular interest. We believe that they are not an expense under the entity theory approach but they are under the proprietary approach. Earnings management continues to be problematic, it just will not go away despite increased laws and media attention. The chapter concludes with some new proposals on income. Of particular interest here is pro forma earnings, an attempt to release income members to financial analysts on a current operating type basis. QUESTIONS Q-1 Describe how definitions of income, revenues, and expenses have changed in statements issued by successive standard-setting bodies. The definitions of income, expenses, and revenues have changed over time. The changes have been from a clearly income statement orientation, i.e., the revenue-expense approach, to a balance sheet orientation, i.e., the asset-liability approach. Q-2 Four points in the revenue cycle, from production through to cash collection, are possible events for revenue recognition. What relevant circumstances would justify finite uniformity rather than rigid uniformity for revenue recognition, and which approach is used in practice? While most businesses recognize revenue at the point of sale, there is limited finite uniformity for certain special industries. The relevant circumstance, of course, is when revenue is judged to be “earned.” So, by custom, methods have evolved that depart from a sale basis of recognition. Among the two major exceptions are during production for long-term construction contracts and cash collection for installment sales (though this is now strongly discouraged, except for tax purposes). In the case of long-term construction contracts, the relevant circumstance is that the time of a contract is so long that meaningful financial statements could not be produced on an annual basis. Hence the “relevant circumstance” is not a cash flow differential but the time factor. Installment sales on a cash basis might be a stretch but the idea is that cash collections might be either very uncertain or difficult to estimate. Q-3 What is the matching concept and why is there an implied hierarchy for expense recognition? Matching is part of the revenue-expense orientation and has as its goal the assignment of costs incurred in the earning of income. The hierarchy recognizes that all costs cannot be directly matched to recognized income, and so allows for a more indirect approach based on a “rational and systematic” allocation over time. Finally, certain costs are so general with respect to revenue generation that they are simply treated as period costs, in effect, independent of any association with revenue. Q-4 Why is there no matching problem for periodic costs, and what are some examples? Period costs are not matched to revenues. Examples include insurance, interest, and certain overheads not allocable to production. Q-5 What types of costs present matching problems, how are they dealt with, and what are some examples of such costs? The main problems arise with indirect matching through arbitrary allocation procedures such as depreciation methods and inventory costing methods. These techniques are simply conventions for allocating costs against revenues over time and bear no necessary relation to the income earning process. Q-6 There has been a trend toward rigid uniformity in the format of the income statement. Explain how and why this has occurred. The trend toward rigid uniformity in the income statement format has occurred primarily in the nonoperating sections. The reason is that with finite uniformity, many financial statement preparers tended to report transactions in a manner that was in their own best interest. The FASB has tended toward rigid uniformity to eliminate those opportunities. Q-7 Why might the distinction between revenues and gains, and between expenses and losses, be important to report yet unimportant as to how they are reported? The issue here concerns disclosure. That is, it may be informative to distinguish between revenues and gains, or expenses and losses, but it may not matter how they are reported, i.e., through disclosure or by being formally reported in the face of the statement. This does ignore that accounting numbers are explicitly used for contract monitoring, and so managers may prefer flexibility (as existed under the current operating performance approach) as opposed to the comprehensive income approach. Q-8 Research, while inconclusive, has shown that earnings are manipulated downward prior to a management buyout. What is the logic of this and why do management buyouts present a difficult agency theory problem? The downward manipulation of earnings would be intended to lower the price that managers would have to pay shareholders for their stock. The conflict of interest arises due to managers both representing shareholders in their management functions and at the same representing their own interests when buying the firm from the shareholders. Q-9 Why is comprehensive income an application of proprietary theory? Comprehensive income tries to show all changes in owners’ equity (except for transactions with shareholders themselves) as elements of income or comprehensive income. Q-10 If a separate statement of comprehensive income is presented, do all elements of comprehensive income appear in this statement? Some elements of comprehensive income are staying in their regular place on the income statement. These include discontinued operations, extraordinary items, and gains and losses arising from changes in accounting principle. In addition, prior period adjustments will still go to retained earnings. Q-11 When dealing with earnings per share, why is less really more with SFAS No. 128? Primary earnings per share, with its common stock equivalent category, was extremely confusing. Hence its elimination makes earnings per share clearer and more understandable. Q-12 Describe the incentives that might motivate income smoothing, and the ways it could be done. The incentives could be to reduce variance in annual earnings numbers, thus reducing risk perception in the marketplace and leading to higher security prices. This is the traditional view of smoothing incentives. More recent research has advanced the argument concerning manager’s inclination to play with accounting policies in response to contracts that use accounting numbers but do not specify in detail the accounting policies to be followed. Smoothing can be achieved by the timing of transactions between periods, by the discretionary choice of accounting policies where such choices exist (e.g., depreciation, inventory, etc.), and by net accruals. Q-13 Why is income smoothing difficult to research, and what are the research findings to date? Smoothing is difficult to “observe” because, if really successful, there is no ready way to determine what unsmoothed earnings would look like. The research in this area suggests that smoothing may be occurring through accruals, policy choices, or classification (prior to APB Opinion No. 30), but the evidence should be viewed with some skepticism given the difficulties raised above. Q-14 Why may interindustry income uniformity be more difficult to achieve than intraindustry uniformity, and what are the implications of this in terms of a conceptual framework project, specific accounting standards, and comparability of accounting income numbers? There is a greater tendency (we believe) to see uniformity in accounting procedures within industry groups. Other things being equal, this should lead to greater uniformity within industries (including income recognition and measurement) than between industries, where greater diversity exists. Lower comparability would exist on an interindustry basis, the usefulness of a conceptual framework could be undermined, and individual standards might be interpreted differently. Q-15 What is the relationship between earnings management and income smoothing? Earnings management is the more general term, with income smoothing being a subset of the former. Earnings management is any type of “purposeful intervention” in the determination and measurement of income used for external purposes. Hence, the whole agency theory area involves earnings management. Income smoothing, as its name implies, tries to even out income with the intention of showing less risk because of less volatility for a given amount of income over the long term. Q-16 Is earnings per share an example of finite or rigid uniformity? The very specific and complex rules underlying EPS indicate an attempt to bring about rigid uniformity. This attempt appears to be successful, now that primary earnings per share has been eliminated. Q-17 Why is the handling of troubled debt restructuring under SFAS No. 114 illogical? The original discount rate is still used, even though it is out of date and no longer applicable. The original rate is probably still used because of its verifiability. Q-18 Why are future events so important to the issue of revenue and expense measurement? The reason is that future events are so pervasive relative to the attempt to measure current transactions. Q-19 Which factor discussed under future events is the most important and why? The most important factor is the probabilistic nature of future events: the probability of an event occurring or not. Choices relative to future events can also be more than “yes” or “no” situations, as in determining depreciable lives, for example. Q-20 From the standpoint of management, are there any differences between attempting to control bad debt expense percentages and research and development expenses? Bad debt expense is a discretionary accrual. The percentage might be changed without a real change in management policy or cost. In the case of research and development costs, a nondiscretionary accrual, any changes in expense would be accompanied by changes in real expenditures which, in turn, could effect revenues. Q-21 Why do you think earnings is managed when it appears that actual income might be less than management’s voluntary forecasts of earnings? A very crucial test for management is whether actual earnings has exceeded forecast. The results here, including estimates of quarterly earnings and their comparison with actual results, can have an important effect upon security prices. Notice also that this comparison falls under the feedback aspect of relevance of SFAC No. 2. Q-22 Evaluate the attempt by the FASB to separate stock options from stock appreciation rights that are payable in cash? This could solve the measurement problem for stock options. The credit side difference-liability versus owners’ equity – is not a germane distinction in our view. Q-23 Should incentive and nonqualified stock options be treated the same on the financials? We do not believe that the relation between market value and strike price at the date of grant is a critical difference. We also do not think that different tax treatment should govern even though it could be considered to be a relevant circumstance. Q-24 In what two different senses is the term pro forma used? These numbers are presented to financial analysts and are intended to provide a better view of “sustainable earnings” by leaving out one-time non-representative events. Hence pro forma earnings are a descendant of the current operating approach to income. The problem is that management has tried to stack the deck by leaving out some negative items which should be in pro forma earnings. The SEC is trying to straighten out this problem. Q-25 In SFAS No. 154, changes in accounting principle result in a restatement, whereas under APB Opinion No. 20, a change in accounting principle is handled in a pro forma manner. How does a restatement differ from a pro forma presentation? Restatements change what was reported (actual); pro formas are “what if” presentations. Q-26 What is classification shifting? Classification shifting is the placement of data in an inappropriate area of the income statement. Bottom line net income will not be affected; however, movement of dollars from COGS to S&A can artificially increase the firm’s gross margin. Alternatively, costs could be moved below the operating income line to increase its appearance of ongoing profitability. You can also find classification shifting on the Balance Sheet to avoid violating loan covenants. On the Statement of Cash Flows dollars may be shifted between Operating and Investing activities to manage how the company’s cash flows appear users of the financials. CASES, PROBLEMS, AND WRITING ASSIGNMENTS 1. Revenue recognition, when the right of return exists, was standardized in 1981 by SFAS No. 48. Prior to this, SOP 75-1 provided guidance but was not mandatory (which is why the FASB has brought various SOPs into the accounting standards themselves). As a result, three methods were widely used to account for this type of transaction: (1) no sale recognized until the product was unconditionally accepted, (2) sale recognized along with an allowance for estimated returns, and (3) sale recognized with no allowance for estimated returns. SFAS No. 48 mandated revenue recognition for such sales subject to six conditions: (1) price is substantially fixed or determinable at sale date; (2) buyer has paid or is obligated to pay the seller, and payment is not contingent on resale of the product; (3) buyer’s obligation would not be changed in the event of theft or physical damage to the product; (4) buyer acquiring the product for resale has economic substance apart from the seller; (5) seller has no significant obligations to bring about resale by the buyer; and (6) future returns can be reasonably estimated. Required: a. Discuss the underlying conceptual issues concerning revenue recognition when the right of return exists. Can any (or all) of the pre-SFAS No. 48 methods be justified? b. Indicate the rationale for each of the SFAS No. 48 tests before a revenue is recognized. c. Is SFAS No. 48 an example of finite uniformity or of circumstantial variables as developed by Cadenhead (see Chapter 9)? d. Discuss the role of future events in SFAS No. 48. (a) Revenue recognition when the right of return exists raises interesting issues concerning whether or not revenue is “earned” at the conventional point of sale. Methods 1 and 2 would be plausible under certain circumstances, but Method 3 would be inconsistent (unless returns were simply not material). What SFAS No. 48 did was to create clear rules in an unregulated area where diversity existed, but presumably was unjustified. (b) Test 1 deals with measurement preconditions for recognition. Test 2 establishes whether or not the earnings process is really complete. Test 3 is evidence that the risk of ownership has passed to the buyer. Test 4 establishes that the transaction is at arm’s length. Test 5 again refers to whether or not the earnings process is complete. Finally, Test 6 is concerned with verifiability. (c) We believe this is a case of circumstantial variables rather than finite uniformity with [6]; the key issue is that future returns are reasonably estimable. The unusual right of return situation is an industry-specific custom that is beyond the control of the firm; hence, it is an environmental condition. A classic example exists in the case of book publishing, where retailers have the right to return books to the publisher long after the “sale” has been made. It would be virtually impossible for an individual book publisher to buck this industry-wide trend. This problem, in turn, leads to verifiability problems in terms of measuring sales. Hence, this is an excellent example of a circumstantial variable. (d) The key future event involves estimating future returns. 2. Accounting for the transfer of receivables with recourse has been problematic. At issue is whether such a transaction is, in substance, a sale, in which case a gain/loss would be recognized, or a financing transaction, in which case any gain/loss should be amortized over the original life of the receivable. (The receivable could be long-term; for example, a sale of an interest-bearing note.) SOP 74-6 concluded that most transfers with recourse are financing transactions based on the argument that a transfer of risk (i.e., no recourse) must exist for a sale to have occurred. In 1983, the FASB reached a different conclusion in SFAS No. 77. A sale is now recognized if (1) the seller surrenders control of future economic benefits embodied in the receivable and (2) the seller’s obligation under the recourse provisions can be reasonably estimated. If these conditions are not met, the proceeds from a transfer are reported on the balance sheet as a liability. Required: a. What is the critical issue in interpreting the nature of this transaction? How does interpretation of the critical issue lead to the two different viewpoints? b. Explain why the SOP 74-6 view represents a revenue-expense orientation, while the SFAS No. 77 represents an asset-liability orientation. (a) The key issue is whether the existence of recourse is a relevant circumstance to distinguish the transaction from a normal factoring of receivables in which there is no recourse to the seller in the event that there is default on the receivables. SOP 74-6 takes a very narrow interpretation and holds that recourse defeats the sale. By con- trast, SFAS No. 77 takes a broad view that a sale of receivables has occurred, even though there is recourse, if the two tests are satisfied. The tests concern the transfer of economic benefits (note that tie-in to SFAC definitions of elements) and the ability to measure (estimate) the seller’s obligations under recourse. (b) SOP 74-6 is a revenue-expense orientation, because the focus is on whether or not the conditions of a sale (of receivables) have been met. SFAS No. 77 adopts an asset- liability view, because the concern is on whether or not the transfer of an asset (the receivables) has occurred. 3. In its 1994 monograph on future events, the FASB discussed several orientations that might be related to asset valuation. As an example of its thinking, assume that we are assessing future sales of a product for the purpose of determining the value of the asset which is used to manufacture the product. The product is expected to sell for $25 per unit. Probability and unit sales are shown here. Probability Estimated Sales .45 0 .10 5000 .30 6000 .15 8000 Required: Part 1: Determine (a) the modal (most likely individual unit sales), (b) the cumulative probability (summed probability of sales being either positive or negative), and (c) the weighted probability number (expected value of probability times estimated sales times sales price). Part 2: How might these approaches be utilized to value the asset which is used to manufacture the product? Part 1 (a) The most likely event is estimated sales of 0 at 45 percent. (b) The cumulative probability approach would take into account the fact that there is a cumulative probability of 55 percent that sales will be positive; hence, some positive value should be assigned to the asset (see part (c)). However, under the cumulative probability approach, if the positive probabilities summed to less than 50 percent, a positive asset value would not be recognized, making the outlook in this situation similar to the modal amount. (c) The “weighted probability” approach is the familiar weighted average approach using sales dollars. Estimated Selling Probability × Sales × Price = Valuation .45 0 $25 = 0 .10 5,000 25 = $12,500 .30 6,000 25 = 45,000 .15 8,000 25 = 30,000 $87,500 Part 2 The approach discussed in the FASB (1994) monograph would appear to be much more useful for management accounting purposes for capital budgeting. The weighted probability approach might be used, but the issue of verifiability relative to estimating sales probabilities should be very carefully weighed before using the method. In addition, if applicable, the $87,500 should be present valued. As mentioned in the report (p. 10), the modal approach probably underlies SFAS No. 2 on research and development: the single most likely outcome of any research and development project is zero from a modal perspective or a cumulative probability perspective (zero payoff probability is above 50 percent). 4. In 1983, a number of computer software companies reported use of an accounting procedure that was investigated by the SEC. The accounting policy is to capitalize the cost of developing computer software and amortize it over the life of the software (usually three to five years). This procedure is used by large and small companies, but the impact is more pronounced on smaller, new companies, in which a greater portion of their activity is devoted to software development. An official of Comserv, a small company that specializes in software, said that small companies would be in deep trouble because of SFAS No. 86. He said smaller companies would be under strong pressure to keep costs down if development costs had to be expensed. He also said, relative to the immediate write-off of these costs that smaller companies would not be able to put as much cash into their own growth and development because of SFAS No. 86. The SEC’s concern was whether this accounting policy was consistent with SFAS No. 2 concerning the expensing of research and development costs as incurred. In 1985, SFAS No. 86 treated software-related research and development costs the same as in SFAS No. 2. Required: a. Evaluate the software capitalization argument with reference to SFAS No. 2. b. Why is the choice of accounting policies (expensing vs. capitalization) more likely to affect smaller companies? c. Comment on the claim that small companies “wouldn’t be able to invest as much cash in their own growth if they couldn’t use [capitalization].” Is this a real economic consequence? d. If you were a FASB member, how would you have voted on this issue? (a) Students should review SFAS No. 2 to establish the relationship between the issue in the cases and the general policy on R&D accounting. It boils down to whether these types of costs are R&D, at least in terms of consistent policy. It is by no means self- evident. These costs could be considered analogous to tool and die costs (which are capitalized), or to both R&D as defined in SFAS No. 2. This dilemma highlights the difficulty in achieving unambiguous accounting policies. (b) Small companies, particularly new ones, are likely to show a wider variation between the two methods, compared with larger, older, and more diversified companies. (c) This is the type of non sequitur that one often finds concerning the economic consequences of accounting policies. Other things being equal, cash flows will be the same regardless of how the costs are allocated to the income statement. The statement implies that companies would have disincentives to invest in software if accounted for like R&D, because of the negative short-term EPS impact. This viewpoint clearly assumes a naive market. (d) In order to be consistent with SFAS No. 2, we would proscribe capitalization. However, a strong case can be made that an economic asset exists, and a higher probability of realization of future cash flows is quite justified. 5. Discuss the role of future events in the following revenue and expense recognition situations. a. Modification of terms under troubled debt restructuring in SFAS No. 114. b. Pension accounting relative to measuring current expense in SFAS No. 87. c. Other postretirement benefits under SFAS No. 106. d. Full costing and successful efforts in oil and gas accounting as well as the SEC’s reserve recognition accounting proposal. (a) The main future event problem concerns to what extent the cash flows from the modification will be paid. The historical interest rate is used rather than determining the current rate (see question 18) applicable to the transaction. (b) Future events dominate the pension and other postretirement benefits situations. In the case of pensions, numerous future circumstances must be considered, such as turnover, mortality, the expected long-term rate of return on plan assets, and expected future salaries. Expected future salaries are wholly executory in nature, and were introduced in SFAS No. 87 for the purpose of helping users to predict future cash flows as opposed to using current salaries, which would provide more of an accountability orientation (see Chapters 8 and 16). Paragraph 169 of the standard also mentions “. . . unwritten but substantive commitment to increase regularly the benefits paid to retirees to reflect inflation . . . ,” which goes beyond the present written plan (though this would appear to be encompassed by estimating future salaries). (c) Similar to pension benefits, other postretirement benefits encompass numerous future events. As with pensions, mortality and turnover must be considered. The service cost component is based upon the amount and timing of future benefits (taking into account mortality and turnover) to be paid to covered employees computed on the basis of expected future costs for these services. Since the future benefits are based upon expected future services to be provided, the verifiability problem is far more difficult to cope with than in the pension situation. Moreover, some future events that would help to contain other postretirement benefit costs, such as plan amendments, employee contributions, and Medicare changes, were not to be considered. Hence, we have a standard steeped in both predicting future cash flows and the use of conservatism (resulting in higher expense calculations), a major inconsistency. (d) Full costing, by capitalizing all drilling, largely avoids major pitfalls of future events except for the number of years selected for the write-off, which is not an excessively difficult problem. In the case of successful events, the decision as to whether to capitalize or expense will be delayed until it is clear that either a productive oil well or a dry hole has resulted, so the major future events problem is avoided. Reserve recognition accounting had to be given up due to problems of future events. These included estimating quantities of discovered petroleum and changes therein, future selling prices, future production, and estimating the timing of future sales. The future event difficulties should have been immediately obvious to the SEC. Accounting Theory (9th edition) Page 12 of 14 6. Shown below is the bottom part of the income statement of Waste Management, Inc., for the year ending December 31, 1998. Also shown below is a note from its financial statements showing the elements of its comprehensive income items, which were shown as part of the statement of changes in equity. Required: a. Recast the income statement for December 31, 1998, so that it includes comprehensive income. b. Even though not allowed by the FASB, compute the EPS for comprehensive income. c. Do you think that elements specific to comprehensive income should be shown only in the statement of changes in equity? d. Do you think there are circumstances in which Waste Management might desire to show comprehensive income elements within the income statement itself? (a) Net Income (per income statement) (770,702) Other Comprehensive Income (net of tax) Foreign currency translation adjustment (77,842) Minimum pension liability adjustment (59,769) (137,611) Comprehensive Income $(908,313) (b) Earnings per share on net income is $(1.32) per share hence the average number of shares outstanding is 583,865,150 (–$770,702,000 ÷ –$1.32). Hence overall earnings per share including comprehensive income would be –$1.556 per share (–$908,313 ÷ 583,865). (c) No, there is too much flexibility that is present with it. We would like to see it shown as part of the income statement itself. Users should still understand the importance of net income before comprehensive income. Comprehensive income elements do not get shunted aside under this approach. (d) They probably would like to show it within income if the elements were positive in total. To be fair to the company they do show a footnote in which comprehensive income elements are added in to net income before comprehensive income (as shown in (a) above). 7. Utilizing the stock options proposal made in this chapter, show entity and proprietary income in the following situation for the Ethan Neil Corporation: Income before taxes $4,810,000 Interest expense 182,000 Stock options expense (incentive) 240,000 Income tax rate 40% Entity Income $4,919,2001 Less: Interest expense $182,000 Tax savings 72,000 $109,200 Stock options expense 240,000 349,200 Proprietary Income $4,570,000 1Add back interest expense net of tax savings. CRITICAL THINKING AND ANALYSIS 1. The question of the usefulness of cost allocations (discretionary accruals and management compensation plans) has been introduced in this and previous chapters. What, if anything, would you do about (fixed) cost allocations? Don’t forget to consider political costs. This ties together the whole question of fixed costs. We are presently in a situation of flexibility. Rigid uniformity, possibly by industry, could increase comparability but corporate managements would say that their ability to tell their “story” was being impeded. Efficient contracting employing finite uniformity would be the ideal. Developing and implementing standards for this would not be easy and would bring up reliability considerations. Opposition by management relative to earnings management and interference with management compensation plans would surely arise but would not be couched in terms of these issues. Also worth mentioning here is the Lev and Zarowin plan for partial capitalization of research and development costs discussed in Chapter 10. All of these approaches would hopefully cut down on manipulation of discretionary accruals. This question would make an excellent term paper project, particularly for graduate students. 2. Moehrle et al. (2010) respond to the FASB regarding possible financial statement presentation changes. Evaluate their response. Moehrle, Stephen, Thomas Stober, Karim Jamal, Robert Bloomfield, Theodore E. Christensen, Robert H. Colson, James Ohlson, Stephen Penman, Shyam Sunder, and Ross L. Watts (2010). “Response to the Financial Accounting Standards Board’s and the International Accounting Standard Board’s Joint Discussion Paper Entitled ‘Preliminary Views on Financial Statement Presentation,’”Accounting Horizons, 149–158. This paper sets forth the American Accounting Association Financial Accounting Standards Committee _hereafter, the committee_ summary comments as well as responses to several of the FASB’s and IASB’s _hereafter, jointly mentioned, the Boards_ specific objectives and principles- related questions. Overall, the committee believes that the model has several appealing features, but also has several potential problems. Many of the problems discussed related to potential learning impediments for users to adapt to the new presentation format. Taken from abstract. 3. Liu and Espahbodi (2014) suggest that a firm’s dividend policy affects its propensity to smooth earnings. How might this finding affect financial statement analysis? Liu, Nan and Reza Espahbodi (September 2014). “Does Dividend Policy Drive Earnings Smoothing?” Accounting Horizons: 501-528. Abstract: “This paper examines the earnings-smoothing behavior of dividend-paying firms. We show that dividend-paying firms engage in more earnings smoothing than nonpayers through both real activities and accrual choices. More specifically, dividend paying firms with positive (negative) pre-managed earnings changes engage in more downward (upward) earnings management than non-payers. Additional tests suggest that the results are driven by dividend-related incentives and not the differences in the economic characteristics of dividend-paying firms, are robust to alternative measures of earnings management, and are not due to spurious correlation. We also show that earnings smoothing, in part, explains the higher earnings persistence of dividend- paying firms. These findings are consistent with a firm’s dividend policy having an incremental impact on earnings-smoothing behavior.” Dividend-paying firms want to smooth earnings so they can maintain their dividend level and payout ratio. This behavior affects risk assessment regarding potential material misstatement in the financial statements. Perhaps a first step before reviewing a company’s financial statements is to determine its dividend-paying policy and its history. Solution Manual for Accounting Theory: Conceptual Issues in a Political and Economic Environment Harry I. Wolk, James L. Dodd, John J. Rozycki 9781483375021, 9781412991698