Chapter 3 Flashcards
Pro forma reporting
Financial reporting the excludes extraordinary items
Primary concerns of regulators and oversight committees regarding pro forma reporting:
- Antifraud provisions: Obviously, these provisions still apply for pro forma reporting. Pro forma cannot be misleading.
- Basis for presentation: Extraordinary items need to be indicated and the reason they’re being excluded should be addressed.
- Timing of the report: Firms can release the pro forma reporting (unaudited) before the audited financials.
- Aggressive accounting
Aggressive accounting
A method of accounting that’s used to report lower expenses and higher income, or to overstate assets while understating liabilities.
True or false: Capitalization is an example of aggressive accounting?
True. Capitalization allows expense recognition to be deferred.
True or false: One of the fundamental concepts of GAAP is to match costs and revenues over time?
True
Ways to measure Depreciation:
- Straight-line
- Accelerated depreciation
a. Double declining balance (DDB)
- With few exceptions, the IRS only allows DDB for accelerated depreciation methods.
Straight-line depreciation
Produces a constant depreciation expense and a constant decline in carrying value of the asset.
Calculation: Original cost ÷ Estimated useful life
- Whenver possible, firms will use an accelerated method for tax reporting purposes and straight line depreciation under GAAP for reporting to shareholders. This will create deferred tax.
Modified Accelerated Cost Recovery System (MACRS)
IRS regulations that require the entire cost of an asset to be written off over its depreciable life.
Double declining balance
An accelerated method of depreciation.
Calculation: (2 * straight-line depreciation rate) * Carrying value
Methods to use for accounting for investments:
- Cost method: When a firm owns <20% of another company. Carried at par.
- Equity method: When a firm owns >=20% but <=50% of another company. Under this method, the firm that owns the shares will report a proportionate share of the investee’s earnings.
- Purchase method: When a firm owns >50% of another company
- In the equity method, the investment is referred to as an affiliate.
Principal characteristics of the purchase method
- Mandatory for use in a cash deal
- Viewed as an acquistion of new assets
- The BV used for PP&E and other fixed assets may be adjusted (increased) to MV.
- Goodwill is created if the acquisition price > MV of the assets acquired.
- If there is an impairment to goodwill, earnings must be written down.
- Minority interest must be created if < 100% is acquired.
- With the purchase method, balance sheets and income statements are combined.
Goodwill calculation
MV of a company’s net tangible assets - price
Net tangible assets calculation
Total assets - liabilities - existing goodwill - intangible assets
- Intangibles with an identifiable market value may be included in the tangible book value per share
3 ways that firms account for investments in stocks and bonds
- Tradable
- AFS
- HTM: Typically, these are highly rated bonds or CDs.
- HTM securities are listed on the b/s at their original cost + any accrued expenses to date.
- HTM securities that will mature in less than a year are classified as CA, whereas if they mature in more than a year they’re considered fixed assets.
- Tradable securities are listed as a CA at MV. URG/URL are recognized in the IS.
- AFS securities are listed at MV.
True or false: Consolidated financial statements MUST be prepared when a firm owns 25% or more of another firm?
False, 50%
Noncontrolling interest/minority interest
An item that’s shown in the equity section of the parent’s b/s.
Noncontrolling interest in net earnings of consolidated companies
An account in the IS that shows how much income in a given period belongs to noncontrolling or minority shareholders (rather than the parent).
Ex: Firm A owns 70% of Firm B and Firm B reports NI of $200M. Firm A and Firm B would consolidate their income statements, and a deduction of ($200M * 30% = $60M) is made under noncontrolling interest.
True or false: FASB requires firms to capitalize the interest incurred during the period of construction of non-current assets?
True
- This is done because if something is in construction, it’s probably not allowing a firm to generate revenue yet. Capitalization is when the interest cost IS NOT included in the interest expense on the IS, but instead included in the cost of the building on the b/s, and is depreciated over the useful life. Once the construction is completed, the interest expense must be included in the IS.
How firms account for leasing an asset
When firms lease an asset, they must create a liability for future lease payments. The liability equals the PV of the lease payments. In order to balance the b/s, leasees will create an asset called the rights of use (ROUs). Since leased equipment and facilities are often used for more than one year, ROUs are generally fixed assets.
Leases will impact the leasee’s IS, but it will depend on if it’s a financial lease or operating lease.
Finance lease vs operating lease
Operting lease: A firm will recognize its lease payments as an operating expense. These expenses are constant over the lease term.
Finance lease: An asset that is likely to be acquired after a lease term is up. Payments for finance leases are split up into an interest component and an amortization component. The interest portion is expensed after operating costs on an IS. Because of this, financing leases give firms higher operating incomes. The amortization component decreases each year.
Finance lease payments decline over the lease term.
- Operating leases are considered more aggressive.
- Finance leases typically decline over the lease term since interest expense will fall and amortization will be constant.
- Finance leases will have higher D/E ratio and lower ROA.
How to test for impairment w/ goodwill:
- Identify any any impairments by comparing MV to the b/s value. If the MV > b/s value, there’s NO impairment.
- If impairment is identified, a loss equal to the excess is recognized in the IS.
True or false: Intangible assets ARE NOT amortized?
False. If the intangible asset has a useful life (ex: copyrights, patents, etc.), it can be amortized.
What are the 2 methods of revenue recognition:
- Percentage-of-completion method
- Completed contract method
Percentage-of-completion method
Revenue is reported each period as the company incurs costs to complete the project.
- Typically used for long-term contracts.
Completed contract method
Revenues nor expenses are recognized until the contract is complete.
True or false: Firms can switch between revenue recognition methods during contracts?
True
- It’s important to understand how earnings are affected by these switches. For example, if a firm is using % of completion method and then switches to the completed contract method, revenues will be lower in the short-term and higher once the contract is completed.
Defined contribution plan
The employer makes a set annual contribution (usually a % of the employee’s salary) to an account managed by a trustee. Employee bears the risk.
- Pension assets are separated from the assets of the firm.
Defined benefit plan
A plan that gaurantees an employee a certain pension benefit, tied to the length of employment at the firm and the employee’s salary. Employer bears the risk.
- ERISA establishes minimum amounts that must be funded every year.
The Employee Retirement Income Security Act (ERISA)
Establishes minimum amounts that must be funded in a pension plan each year. The amount expensed and the amount contributed can differ dramatically. If pension assets > pension liabilities, the plan is overfunded and if vice versa, it’s underfunded.
Normal service cost
The amount that current employees earn toward their pension.
- The amt expensed by firms is the PV of these benefits.
Interest of the projected benefit obligation
The liability associated w/ the accumulated normal service cost, incorporating various assumptions like years to retirement and assumed salary increases. Interest accrues on the projected benefit obligation, which is a PV figure and represents part of pension expense in the IS.
Prior service cost
Changes to the pension plan can cause an additional expense, such as an increase in benefit payable under a defined benefit plan. Accounting standards allow firms to amortize these changes over the life of its work force.
True or false: Interest rate increases will increase the value of pension fund assets?
False. If interest rates decrease, pension fund assets will increase. However, pension fund obligations will rise even faster since long-term obligations will cost more to fund in PV dollars- a lower discount rate = higher PV. If this trend continues, it coud lead to unfunded pension liabilities.
- Conservative accounting for pension funds assumes low discount rates, high-assumed rate of salary growth.
DTAs vs DTLs
DTAs/prepaid tax income: If taxable income > accounting income
DTLs: If accounting income > taxable income
How to determine if there is a DTA or DTL?
Deferred tax = Income tax expense (accounting income * tax rate) - current tax (taxable income * tax rate)
If positive, it’s a DTL. If negative, it’s a DTA.
How to account for cash dividends.
When a dividend is declared:
There’s a difference in accounting for cash dividends based on dividend declaration and payment of the dividend. When a cash dividend is declared, dividends payable increase (a CL), and RE are reduced.
When a dividend is paid:
When the dividend is paid, cash (a CA) is reduced and dividends payable are also reduced. Therefore, the reduction of assets (cash) is shown in the reduction of equity (RE).
- When a dividend is declared, the current ratio and WC will be reduced.
- When a dividend is paid, WC remains the same.
