- 1. Chapter 24: Full Disclosure in Financial Reporting (pages:
1281-1348)LEARNING OBJECTIVES1. Review the full disclosure
principle and describe implementation problems.2. Explain the use
of notes in financial statement preparation.3. Discuss the
disclosure requirements for major business segments.4. Describe the
accounting problems associated with interim reporting.5. Identify
the major disclosures in the auditors report.6. Understand
managements responsibilities for financials.7. Identify issues
related to financial forecasts and projections.8. Describe the
professions response to fraudulent financial reporting. *9.
Understand the approach to financial statement analysis.*10.
Identify major analytic ratios and describe their calculation.*11.
Explain the limitations of ratio analysis.*12. Describe techniques
of comparative analysis.*13. Describe techniques of percentage
analysis.*14. Describe the current international accounting
environment. *This material is covered in an Appendix to the
chapter. LECTURE OUTLINEA. Full Disclosure Principle: Report any
financial facts significant enough to influence thejudgment of an
informed reader. 1. Recent trends in financial reporting reflect an
increase in the amount of disclosure found infinancial statements.
2. Increased disclosure is a result of the efforts of the SEC and
the FASB. 3. The pronouncements issued by these organizations
include many disclosurerequirements that are designed to improve
the financial reporting process. 4. Issues to be considered:(a)
Costs of Disclosure.(b) Information Overload.(c) The increase in
disclosure requirements is linked to:(1) Complexity of the Business
Enterprise.(2) Necessity for Timely Information.(3) Accounting as a
Control and Monitoring Device. 24-1
2. TYPES OF FINANCIAL INFORMATION 24-2 3. B. Notes to the
Financial Statements: 1. A means of full disclosure and providing
qualitative and supplementary data 2. Integral part of financial
statements 3. Summary of Significant Accounting Policies. a. Should
be the first note. b. informs the statement reader of the
accounting methods used in preparing the information included in
the financial statements. c. policies are specific accounting
principles and methods currently employed and considered most
appropriate in the circumstances to present fairly the financial
statements of the enterprise. 4. Inventory (Chapter 9). The basis
upon which inventory amounts are stated and the method used in
determining cost. a. lower of cost or market b. LIFO, FIFO, Average
Cost 5. Property, Plant, and Equipment (Chapter 11).a. The basis of
valuation (usually historical cost), pledges, loans, or other
commitments related to these assets.b. For depreciation: period
expense, balances of major classes of depreciation assets, and
balance of accumulated depreciation by major class or in total. 6.
Creditor Claims (Chapter 14).a. A liability may have numerous
covenants that are not conveniently disclosed in the liability
section of the balance sheet.b. disclose financing operations,
costs to be borne in future periods, and timing of future cost
outflows.c. Disclose for each of 5 years after financial statement
date the aggregate amount of maturities and sinking fund
requirements for all long-term borrowings. 7. Equity Holders Claims
(Chapters 15 and 16). a. The rights of various equity security
issues b. unique features that may apply to certain issues are
commonly24-3 4. c. number of shares authorized, issued and
outstanding d. stock options, convertible securities, e. types of
restrictions on the amount of earnings available for dividend
distribution. 8. Contingencies and Commitments (Chapters 7, 9, and
13). a. contingent gains or loss disclosure provides relevant
information to financialstatement users. b. litigation, debt, and
other guarantees, possible tax assessments, c. renegotiation of
government contracts, sales of receivables with recourse, and so
on. d. dividend restrictions, purchase agreements, hedge contracts,
and employmentcontracts. 9. Deferred Taxes, Pensions, and Leases
(Chapters 19, 20, and 21). a. Extensive disclosures are required b.
Should provide information about off-balance-sheet commitments,
futurefinancing needs, and the quality of a companys earnings.10.
Changes in Accounting Principles (Chapter 22). a. changes in
accounting principles b. material changes in estimates and
corrections of errors.C. Disclosure of Special Transactions or
Events. 1. Related Party Transactions: a. Transactions which have
not been carried out on an arms-length or freemarket basis. b. SFAS
57 requires that the nature of the relationship, a description of
thetransaction, and the dollar amounts involved be disclosed.(1)
Errors (unintentional mistakes) and irregularities (intentional
distortions of financial statements).(2) Illegal Acts. 24-4 5. 2.
Subsequent Events. a. Events that occur subsequent to date of the
financial statements, but before issuance. b. Events that provide
additional evidence about conditions that existed at the balance
sheetdate, and that require adjustments be made. c. Events that
provide evidence about conditions that did not exist at the balance
sheetdate but arise subsequent to that date, and that do not
require adjustments be made. D. Reporting for Diversified
(Conglomerate) Companies. 1. Importance of segment data in seeing
how different product lines contribute to the firmsprofitability,
risk, and growth potential. 2. report revenue and income
information on the individual segments that comprise the
totalbusiness income figure. 3. In 1976 the FASB issued Statement
No. 14, Financial Reporting for Segments of a BusinessEnterprise
and in 1997 it issued FASB Statement No 131, Reporting
DisaggregatedInformation about a Business Enterprise. 4. Pros and
Cons of Disclosing Segment Information. a. Reasons against
disclosing segment information:(1) Data which is meaningless for,
or misleading, to investors.(2) Competitive harm.(3) Adverse impact
on internal decisions.(4) Limited usefulness.(5) Investor should be
concerned with overall, not segment, performance.(6) Difficulty in
allocating common costs. b. Reasons for segmented data
disclosure:(1) Intelligent decision making by investors.(2)
Complete disclosure by all firms (both diversified companies and
single product-linecompanies) creates a better competitive
environment.24-5 6. 5. The basic reporting requirements of
disaggregated information are: a. Objective of Reporting
Disaggregated Information provides informationabout the different
types of business activities and economic conditions thecompany
operates in. b. Allows users to: (1) Better understand the
enterprises performance. (2) Better assess its prospects for future
net cash flows. (3) Make more informed judgments about the
enterprise as a whole.c. Basic Principles. (1) General purpose
financial statements are required to include selectedinformation on
a single basis of disaggregation. (2) The method chosen is referred
to as the management approach(a) based on the way the management
disaggregates the company for making operating decisions.(b)
Evident from organization structured. An operating segment is a
component of an enterprise: (1) That earns revenues and incurs
expenses. (2) regularly reviewed by the companys chief operating
decision maker toassess segment performance and allocate resources
to the segment. (3) has discrete financial information available
that is generated by orbased on the internal financial reporting
system.e. aggregate information only if the segments have the same
basic characteristics in each of the following areas: (1) The
nature of the products or services provided. (2) The technology
underlying the production process. (3) The type of class of
customer. (4) The methods of product or service distribution.
(5)The economic characteristics of their markets.24-6 7. 6. Tests
for significance:a. Made to determine if a segment is significant
enough to warrant disclosure.b. Must satisfy at least one of the
following: (1) Its revenue is 10% or more of all the segments. (2)
The absolute amount of its profit or loss is 10% or more of the
greater, in absoluteamount, of: (a) The combined operating profit
of all operating segments that did not incur a loss, or (b) The
combined loss of all operating segments that did incur a loss. (c)
Its identifiable assets are 10% or more of the combined assets of
all operatingsegments.7. Additional factors:a. Segmented results to
be disclosed, based on the tests for significance, must equal
orexceed 75% of the combined sales to unaffiliated customers, andb.
The maximum number of segments disclosed does not exceed 10.8.
Measurement principles:a. Accounting principles used for segment
disclosure need not be the same as those used to prepare the
consolidated statements. b. Allocations to segments are assumed to
be directly attributable or reasonably allocable.9. Segmented
information reported: FASB requires an enterprise to report: a.
General information about its operating segments. b. Segment profit
and loss and related information. (1) Revenues from transactions
with external customers. (2) Revenues from transactions with other
operating segments. (3) Interest revenue and expense. (4)
Depreciation, depletion, and amortization expense. (5) Unusual
items.24-7 8. (6) Equity in the net income of investees accounted
for under the equity method.(7) Income tax expense or benefit.(8)
Extraordinary items.(9) Significant noncash items other than
depreciation, depletion, and amortization expense. c. Segment
assets. d. Reconciliations.(1) Total operating segments profits and
losses to the companys income before taxes.(2) Total operating
segments assets to total assets of the company. e. Information
about products and services and geographic areas.(1) Revenues from
external customers.(2) Long-lived assets.(3) Expenditures during
the period for long-lived assets. This information, if material,
must be reported in the companys country of domicile and each other
country. f. Major customers: disclose the total amount of revenues
from each customer that accounts for 10% or more of the segments
revenues.E. Interim Reports.1. financial reports issued by a
business enterprise for a period of less than one year.2. The SEC
requires certain companies coming under its control to file
quarterly financial statements similar in form and content to their
annual reports.3. Guidance in the area of accounting and reporting
for interim periods iscurrently provided by APB Opinion No. 28,
Interim Financial Reporting.4. FASB is now working on improvements
in interim reporting standards. a. APB Opinion No.28 indicates that
the same accounting principles used forannual reports should be
applied in preparing interim reports. b. general approach used in
preparing these reports is the subject of some debate.24-8 9. c.
Two different approaches have been advocated in practice. (1)
discrete approach - each interim period should be treated as a
separateaccounting period (2) integral approach- the interim report
to be an integral part of the annual report. (3) At present, many
companies follow the discrete approach for certain types ofexpenses
and the integral approach for others, because the standards
employed atpresent are fairly flexible. (4) In APB Opinion No. 28,
the Board indicated that it favored the integral approach
inpreparing interim reports.(a) certain items do not lend
themselves to strict application of the guideline.(b) unique
reporting problems are encountered for(c) advertising and similar
costs(d) expenses subject to year-end adjustments(e) income
taxes(f) extraordinary items(g) earnings per share(h)
seasonality.5. APB Opinion No. 28 requirements a. Exceptions
allowed for inventory pricing.(1) The use of the gross profit
method.(2) LIFO liquidation.(3) Temporary inventory market
declines.(4) Planned variances expected to be absorbed should be
deferred. b. Period costs.(1) May be expensed as incurred or(2)
allocated among interim periods on the basis of an estimate of time
expired, benefit received, or activity associated with the periods.
24-9 10. c. Minimum disclosures. (1) Sales or gross revenues,
provision for income taxes, extraordinary items, cumulative effect
of a change in accounting principle or practice, and net income.
(2) Basic and diluted EPS where appropriate. (3) Seasonal revenue,
cost, or expenses. (4) Significant changes in estimates or
provisions for income taxes. (5) Disposal of a segment,
extraordinary, unusual, or infrequently occurring items. (6)
Contingent items. (7) Changes in accounting principles or
estimates. (8) Significant changes in financial position.6.
Problems Unique to Interim Reporting. a. Advertising and Similar
Costs: Should such costs be deferred in aninterim period if the
benefits extend beyond that period? b. Expenses Subject to Year-End
Adjustment: Examples such as baddebts and executive bonuses. These
costs should be estimated andallocated to interim periods. c.
Income Taxes: The estimated annual effective tax rate should be
used. d. Extraordinary Items: Charge or credit the gain or loss in
the quarterthat it occurs instead of allocating. e. Earnings Per
Share: In computing EPS each interim period stands alone. f.
Seasonality: The seasonal nature of the business should be
disclosed.24-10 11. 24-11 12. F. Auditors report. 1. issued each
time an independent auditor performs an audit of an
entitysfinancial statements. 2. the expression of an opinion, by
the auditor, on the fairness with which thefinancial statements
present the entitys financial position and results ofoperations. 3.
Reporting standards.a. Must state whether the financial statements
are presented in accordance with GAAP.b. Must state those
circumstances where consistency does not exist.c. Disclosures are
to be regarded as reasonably adequate, unless otherwisestated in
the report.d. Must contain an expression of opinion regarding the
financial statements taken as a whole or an assertion to the effect
that an opinion cannot be expressed. 4. Opinions which the auditor
may express: a. unqualified, b. qualified, c. adverse, or d.
disclaimer of opinion. 5. Standard unqualified opinion with
explanatory paragraph.a. Uncertainties.b. Lack of consistency.c.
Emphasis of a matter. 6. Reasons for departure from unqualified
opinion. a. Scope of examination is limited or effected by
conditions or restrictions. b. Statements do not fairly present
financial position or results of operationsbecause of lack of
conformity with GAAP and/or inadequate disclosure. c. Departures
from an unqualified opinion put the financial statement reader
onguard as to possible deficiencies in the presentation of the
financial statements. 24-12 13. d. When the auditor departs from
the standard unqualified audit report, the reason for the departure
must be clearly indicated in the audit report.G. Managements
discussion and analysis (MD&A).1. SEC requires corporate
management to include a disclosure in the corporate annual report
referred to as management discussion and analysis (MD&A).a.
Requires management to highlight favorable or unfavorable trends
and to identify significant events and uncertainties that affect:
(1) Liquidity. (2) Capital resources. (3) Results of operations. 2.
MD&A must provide information concerning the effects of
inflation and changing prices, if material to financial statement
trends. 3. Managements responsibilities for financial statements.
a. The Sarbanes-Oxley act requires the SEC to develop guidelines
for all publicly tradedcompanies to report on managements
responsibilities for the preparation of thefinancial statements,
and (1) The establishment and maintenance of a system of internal
controls. (2) The purposes of this report are: (a) to increase the
investors understanding of the roles of management and theauditor
in preparing financial statements, and (b) to heighten the
awareness of senior management of its responsibilities for
thecompanys financial and internal control system. b. Information
related to the social concerns of a business enterprise has
received agreat deal of attention in recent years. (1) potential
investors are interested in an entitys concern for protection of
theenvironment. (2) In response to this concern, the SEC requires
that the following types of environmental information be disclosed
in filings with that agency. (a) The material effects that
compliance with federal, state, and local environmentalprotection
laws may have upon capital expenditures, earnings, and
competitiveposition. 24-13 14. (b) Litigation commenced or known to
be contemplated against registrants by a government authority
pursuant to federal, state, and local environmental regulatory
provisions. (c) All other environmental information of which the
average prudent investor ought reasonably to be informed.H.
Reporting on Financial Forecasts and Projections. 1. The AICPA has
issued a statement on standards for the preparation of
prospectivefinancial statements.a. Prospective financial statements
are financial statements based upon the entitysexpectations about
future operation.b. There are two types of prospective financial
statements:(1) financial forecasts, and(2) financial projections.
2. financial forecasts is composed of prospective financial
statements that present, itsexpected financial position, results of
operations, and cash flows. 3. A financial projection is composed
of prospective financial statements that present whatmight take
place in regards to the financial position, results of operations,
and cash flows. 4. Arguments for requiring published forecasts:a.
Better decision-making information b. Already circulated
informally. c. Historical cost information may not be adequate.5.
Reasons against requiring published forecasts: a. Problems with
accuracy. b. Impact on internal decisions. c. Legal liability. d.
Competitive harm. e. SEC safe harbor rule. f. Experience in Great
Britain. g. Questions of liability. 24-14 15. h. Internet financial
reporting. I. Fraudulent Financial Reporting. 1. The National
Commission on Fraudulent Financial Reporting defined fraudulent
financial reporting as intentional or reckless conduct, whether act
or omission that results in materially misleading financial
statements.a. Situational pressures on the companyb. individual
pressures on management personnel which lead to fraudulent
financial reportingc. A weak corporate climate contributes to these
situations. 2. The Sarbanes-Oxley Act of 2002, raised the penalty
substantially for executives who are involved infraudulent
financial reporting.24-15
