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 auditor’s report.6. Understand management’s responsibilities for financials.7. Identify issues related to financial forecasts and projections.8. Describe the profession’s 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.
A. Full Disclosure Principle: Report any financial facts significant enough to influence the judgment of an informed reader.
1. Recent trends in financial reporting reflect an increase in the amount of disclosure found in financial 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 disclosure requirements 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.
TYPES OF FINANCIAL INFORMATION
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 commonly
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 financial statement 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 employment contracts.
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, future financing needs, and the quality of a company’s 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 free market basis.
b. SFAS 57 requires that the nature of the relationship, a description of the transaction, and the dollar amounts involved be disclosed.
(1) Errors (unintentional mistakes) and irregularities (intentional distortions of financial statements).
(2) Illegal Acts.
2. Subsequent Events. 24-4
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 sheet date, and that require adjustments be made.
c. Events that provide evidence about conditions that did not exist at the balance sheet date 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 firm’s profitability, risk, and growth potential.
2. report revenue and income information on the individual segments that comprise the total business income figure.
3. In 1976 the FASB issued Statement No. 14, “Financial Reporting for Segments of a Business Enterprise” and in 1997 it issued FASB Statement No 131, “Reporting Disaggregated Information 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-line companies) creates a better competitive environment.
5. The basic reporting requirements of disaggregated information are:
a. Objective of Reporting Disaggregated Information provides information about the different types of business activities and economic conditions the company operates in.
b. Allows users to:
(1) Better understand the enterprise’s 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 structure
d. An operating segment is a component of an enterprise:
(1) That earns revenues and incurs expenses.
(2) regularly reviewed by the company’s chief operating decision maker to assess segment performance and allocate resources to the segment.
(3) has discrete financial information available that is generated by or based 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.
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 absolute amount, 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 operating segments.
7. Additional factors:
a. Segmented results to be disclosed, based on the tests for significance, must equal or exceed 75% of the combined sales to unaffiliated customers, and
b. 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.
(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.
(1) Total operating segments’ profits and losses to the company’s 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 company’s 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 segment’s 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 is currently 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 for annual reports should be applied in preparing interim reports.
b. general approach used in preparing these reports is the subject of some debate.
c. Two different approaches have been advocated in practice.
(1) discrete approach - each interim period should be treated as a separate accounting 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 of expenses and the integral approach for others, because the standards employed at present are fairly flexible.
(4) In APB Opinion No. 28, the Board indicated that it favored the integral approach in preparing 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
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.
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 an interim period if the benefits extend beyond that period?
b. Expenses Subject to Year-End Adjustment: Examples such as bad debts and executive bonuses. These costs should be estimated and allocated 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 quarter that 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.
F. Auditor’s report.
1. issued each time an independent auditor performs an audit of an entity’s financial statements.
2. the expression of an opinion, by the auditor, on the fairness with which the financial statements present the entity’s financial position and results of operations.
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 otherwise stated 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:
c. adverse, or
d. disclaimer of opinion.
5. Standard unqualified opinion with explanatory paragraph.
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 operations because of lack of conformity with GAAP and/or inadequate disclosure.
c. Departures from an unqualified opinion put the financial statement reader on guard as to possible deficiencies in the presentation of the financial statements.
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. Management’s 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:
(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. Management’s responsibilities for financial statements.
a. The Sarbanes-Oxley act requires the SEC to develop guidelines for all publicly traded companies to report on management’s responsibilities for the preparation of the financial statements, and
(1) The establishment and maintenance of a system of internal controls.
(2) The purposes of this report are:
(a) to increase the investor’s understanding of the roles of management and the auditor in preparing financial statements, and
(b) to heighten the awareness of senior management of its responsibilities for the company’s financial and internal control system.
b. Information related to the social concerns of a business enterprise has received a great deal of attention in recent years.
(1) potential investors are interested in an entity’s concern for protection of the environment.
(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 environmental protection laws may have upon capital expenditures, earnings, and competitive position.
(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 prospective financial statements.
a. Prospective financial statements are financial statements based upon the entity’s expectations 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, its expected financial position, results of operations, and cash flows.
3. A financial projection is composed of prospective financial statements that present what might 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
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 company
b. individual pressures on management personnel which lead to fraudulent financial reporting
c. A weak corporate climate contributes to these situations.
2. The Sarbanes-Oxley Act of 2002, raised the penalty substantially for executives who are involved in fraudulent financial reporting.