Financial Reporting And Analysis, 7th Edition Class Notes

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CHAPTER 1
THE ECONOMIC AND INSTITUTIONAL SETTING FOR
FINANCIAL REPORTING
CHAPTER OVERVIEW
Financial statements are an extremely important source of information about a company,
its economic health, and its prospects. They help improve decision making and make it
possible to monitor managers’ activities.
 Equity investors use financial statements to form opinions about the value of a
company and its stock.
 Creditors use statement information to gauge a company’s ability to repay its debt
and to check whether the company is complying with loan covenants.
 Stock analysts, brokers, and portfolio managers use financial statements as the
basis for their recommendations to investors and creditors.
 Auditors use financial statements to help design more effective audits by spotting
areas of potential reporting abuses.
Investors, creditors, and other interested parties demand financial statements because the
information is useful. But what governs the supply of financial information?
 Mandatory reporting is a partial answer. Most companies in the United States and
other developed countries are required to compile and distribute financial
statements to shareholders and to file a copy with a government agency (in the
United States, that agency is the SEC). This requirement allows all interested
parties to view the statements.
 The advantages of voluntary disclosure are the rest of the answer. Financial
information that goes beyond the minimum requirements can benefit the
company, its managers, and its owners. For example, voluntary financial
disclosures can help the company obtain capital more cheaply or negotiate better
terms from suppliers. But benefits like these come with potential costs:
information collection, processing, and dissemination costs; competitive
disadvantage costs; litigation costs; and political costs. This means that two
companies with different financial reporting benefits and costs are likely to
choose different accounting policies and reporting strategies.
Different companies choose different accounting policies and reporting strategies because
financial reporting standards are often imprecise and open to interpretation. This
imprecision gives managers an opportunity to shape financial statements in ways that
allow them to achieve specific reporting goals.
 Most managers use their accounting flexibility to paint a truthful economic
picture of the company.
 Other managers mold the financial statements to mask weaknesses and to hide
problems.

 Analysts who understand financial reporting, managers’ incentives, and the
accounting flexibility available to managers will maintain a healthy skepticism
about the numbers and recognize that financial statements sometimes conceal
more than they reveal.
The accountant’s and analyst’s job is made more difficult when financial reporting
measurement and disclosure rules differ across national boundaries. Reporting rules in
some countries such as Canada, the United Kingdom, and the United States evolved to
reflect firms’ underlying economic performance. But reporting rules in many other
countries—France, Germany, and Japan, for example—merely complied with taxation or
other statutory requirements.
 Globalization forced many firms in countries using a commercial or tax law
approach to seek foreign capital. In turn, this has led countries around the world to
move to IFRS, making it easier for firms in their countries to raise capital in
domestic and foreign financial markets.
 The FASB and IASB have worked to converge the guidance for numerous
accounting issues. However, in many cases, the boards have issued substantially
different standards after having worked together originally.
CHAPTER OUTLINE
I. Why Financial Statements Are Important
Teaching Tip: While financial statements are not as timely as press releases,
they do provide aneconomic history and are indispensable in developing an
accurate profile of ongoing performance and prospects.
Teaching Tip: This text does not focus on assisting readers of financial
statements in detecting fraud, which is rare. Rather, the purpose of this text is to
assist readers in understanding the financial flexibility and discretion inherent in
financial accounting rules in order that they may make more informed decisions.
II. Economics of Accounting Information
A. Demand for Financial Statements
B. Disclosure Incentives and the Supply of Financial Information
III. A Closer Look at Professional Analysts
A. Analysts’ Decisions
IV. Fundamental Concepts of Financial Reporting
A. Generally Accepted Accounting Principles
B. Who Determines the Standards?
C. The Politics of Accounting Standards
D. FASB Accounting Standards Codification™
Teaching Tip: It may be a good idea to access the FASB Codification and
provide an overview of how to use the system and reinforce that everything in
the Codification is a Generally Accepted Accounting Principle.

V. Incentive Conflicts and Financial Reporting
Teaching Tip: For example, the choice to capitalize, rather than expense
amounts, will make firms appear to be larger, more profitable, and less risky.
Therefore, naive acceptance of financial statement data may be dangerous.
Much of the book is devoted to providing students with the skills necessary to
become more informed readers of financial statements by making meaningful
comparisons between companiesand gaining insight into managers’
incentives.
VI. An International Perspective
A. International Financial Reporting
VII. APPENDIX 1A: GAAP in the United States
A. Early Developments
B. Emergence of GAAP
C. Current Institutional Structure in the United States
CHAPTER QUIZ
1. A company’s financial statements reflect information about
a. product information and competitive positions.
b. future projections of sales, expenses, and other future economic events.
c. the general economy of the industry in which the company operates.
d. economic events that affect a company that can be translated into accounting
numbers.
2. Creditors assess credit risk by comparing a firm’s required principal and interest
payments to estimates of the firm’s current and future
a. cash flows
b. net assets.
c. revenue.
d. net income.
3. Which is not correct regarding Regulation Fair Disclosure (Reg FD)?
a. It limits what management can say in private conversations with analysts and
investors.
b. It does not limit what management can say in private conversations with analysts
or investors.
c. It was passed by the SEC.
d. It helps level the playing field between individual and institutional investors.
4. Being verifiable and neutral is part of what makes financial information
a. consistent.
b. comparable.
c. relevant.
d. useful

5. Financial information capable of making a difference in a decision is
a. relevant.
b. reliable.
c. consistent.
d. verifiable.
6. Factors that may influence a decision maker’s judgment as to what accounting
information is useful include:
a. The decision to be made.
b. The information already possessed.
c. The decision maker’s capacity to process the information.
d. All of the above answers are correct.
7. Which one of the following types of disclosure costs is the cost of disclosing the
company’s pricing strategies?
a. Political cost
b. Litigation cost
c. Competitive disadvantage cost
d. Information collection, processing, and dissemination cost
8. Employees demand financial statement information because the firm’s performance is
often linked to
a. Employee stock ownership plans.
b. Social security benefits.
c. Disability plan benefits.
d. Workmen’s compensation benefits.
9. The primary current source of generally accepted accounting principles for
publicly traded companies in the United States rests with the:
a. Securities and Exchange Commission.
b. New York Stock Exchange.
c. Financial Accounting Standards Board.
d. American Institute of Certified Public Accountants.
10. International accounting standards are established by the
a. Securities Exchange Commission
b. London Stock Exchange
c. International Accounting Standards Board
d. Institute of Chartered Accountants
Essay Questions
1. Define the expanded role of the PCAOB in the preparation of consistent and
transparent financial statements.
2. Why would it be beneficial to narrow international differences in accounting rules for
accounting and reporting?

QUIZ ANSWERS:
1. D. The financial statements present historical information about what has happened
to the company in the past.
2. A. Creditors are concerned with a firm’s ability to replay principal and interest by
projecting cash flows.
3. B. Reg FD was passed to limit what management can say in private to analysts and
investors.
4. D. Useful information is verifiable and neutral.
5. A. Relevant information is capable of making a difference in decision making.
6. D. The judgment by a decision maker as to what accounting information can be
useful includes the decision to be made, the information already possessed, and the
decision maker’s capacity to process the information.
7. C. Competitive disadvantage cost is the cost of disclosing the company’s pricing
strategies
8. A. Managers and employees use financial information to monitor employee contracts
such as bonus plans, profit–sharing plans, and pension plans.
9. C. The FASB is charged with the responsibility of establishing financial accounting
standards.
10. C. The IASB is responsible for establishing IFRS.
RECOMMENDED FIGURES AND EXHIBITS
1. Figure 1.1—Desirable Characteristics of Accounting Information

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CHAPTER 2
ACCRUAL ACCOUNTING AND INCOME DETERMINATION
CHAPTER OVERVIEW
 This chapter highlights the key differences between cash and accrual income
measurement.
 In most instances, accrual-basis revenues do not equal cash receipts and accrual
expenses do not equal cash disbursements.
 The principles that govern revenue and expense recognition under accrual
accounting are designed to alleviate the mismatching of effort and
accomplishment that occurs under cash-basis accounting.
 The matching principle determines how and when the assets that are used up in
generating the revenue or that expire with the passage of time are expensed.
 Relative to current operating cash flows, accrual earnings generally provide a
more useful measure of firm performance and serve as a more useful benchmark
for predicting future cash flows.
 Predicting future cash flows and earnings is critical to assessing the value of a
firm’s shares and its creditworthiness.
 Multiple-step income statements are designed to facilitate this forecasting
process by isolating the more recurring or sustainable components of earnings
from the nonrecurring or transitory earnings components.
 GAAP disclosure requirements for various types of accounting changes also
facilitate the analysis of company performance over time.
 This chapter outlines some common ways earnings are managed, some of which
have come under SEC scrutiny. Auditors and financial statement users must be
aware of the incentives to manage earnings and the ways in which this is
accomplished.
 Once discovered, accounting errors or irregularities must be corrected and
disclosed through restatement.
 Public companies must report EPS numbers on the face of their income
statements. All firms report basic EPS based on the weighted average number of
shares actually outstanding during the period, while firms with complex capital
structures also disclose diluted EPS, which reflects the EPS that would result if
all potentially dilutive securities were converted into common shares.
 Certain changes in net assets resulting from incomplete or open transactions
bypass the income statement and are reported as direct adjustments to
stockholders’ equity. These direct adjustments are called other comprehensive
income components. Under U.S. GAAP, firms are required to report the
components of other comprehensive income in either a single-statement format
or a two-statement format.
CHAPTER OUTLINE
I. Cash Flow Versus Accrual Income Measurement
A. Articulation of Income Statement and Balance Sheet
B. Revenue Recognition—General Concepts
C. Expense Recognition

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Teaching Tip: For-profit entities adopt accrual accounting because of its
ability to provide investors and creditors with a more realistic picture of
relevant economic events and their effects on firm activities.On the other hand,
entities that do not have a profit motive may prefer a cash-basis accounting
system because of its simplicity.
II. Income Statement Format and Classification
A. Income from Continuing Operations
B. Discontinued Operations
C. Frequency and Magnitude of Various Categories of Transitory Income
Statement Items
Teaching Tip: In forecasting future cash flows, a reader of the financial
statements must determine whether the “special or unusual items” are
sustainable or transitory. The increased occurrence of these items heightens the
speculative nature of these forecasts. It is important to remember that financial
statements are designed to measure the economic conditions (micro and macro)
and financial management of the company to assist users in determining future
cash flows. Companies doing well in a great economic environment may be in
trouble during the next economic turn while a company that exceeds the
competition results during a recession may emerge as a market leader.
III. Reporting Accounting Changes
A. Change in Accounting Principle
B. Change in Accounting Estimate
C. Change in Reporting Entity
Teaching Tip: Changes in accounting principles generally do not result in
direct changes in cash flows. The only exception is a change from the LIFO
method of accounting for inventory (because of the LIFO conformity rule).
Since changes in accounting principles generally do not affect the tax return, a
change in principles used for financial reporting purposes affects only income
tax expense and deferred income taxes.
IV. Earnings Management
A. Popular Earnings Management Devices
V. Accounting Errors, Earnings Restatements, and Prior Period Adjustments
VI. Earnings per Share
VII. Comprehensive Income and Other Comprehensive Income
VIII. Global Vantage Point
IX. APPENDIX 2A: Review of Accounting Procedures and T-Account Analysis
A. Understanding Debits and Credits
B. Adjusting Entries
C. Posting Journal Entries to Accounts and Preparing Financial Statements
D. Closing Entries
E. Accounts Analysis as an Analytical Technique

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Teaching Tip: There are several mnemonic devices available to help students
organize the effects of debits and credits on the different types of accounts.
CHAPTER QUIZ
1. High Tower, Inc. owns and operates resort campgrounds in the U.S. It sells annual
memberships that allow a member’s family unlimited use of the company’s
campgrounds for a one-year periodfor an annual membership fee. Assuming High
Tower produces quarterly financial statements, how should it recognize membership
revenue?
a. Revenue should be recognized when the cash is received. .
b. Revenue should be recognized at the end of the membership period.
c. Membership sales should be recognized equally over the course of the year.
d. Membership sales should be recognized based on members’ actual use of the
facilities.
2. The matching principle encourages:
a. The recognition of expenses when cash is paid for supplies.
b. The recognition of expenses in the same period as the revenue was recognized.
c. The reconciliation of net income and comprehensive income in a separate
financial statement.
d. The recording of period costs on the balance sheet.
3. When a company has decided to dispose of a component of its business which of the
following is true?
a. The income or loss from that component should be reported as a component of
operating income.
b. The income or loss from that component should be separated as an unusual item.
c. The income or loss from that component should not be included on the income
statement.
d. The income or loss from that component should be reported as a discontinued
operation.
4. If a company adopts a new FASB standard, it should be reported as
a. change in accounting principle.
b. change in accounting estimate.
c. change in accounting entity.
d. unusual item.
5. The use of accounting flexibility to meet earnings benchmarks is called
a. impression management.
b. earnings management.
c. profit manipulation.
d. accounting irregularities.
6. Accounting errors or irregularities can occur for which reasons?
a. Simple oversight
b. Misapplication of GAAP
c. management exploitation of the flexibility in GAAP

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d. All of these answer choices are correct.
7. The purpose of reporting nonrecurring items, net of related income taxes, below
income from continuing operations is:
a. These items help explain deviations in current year net income from past trends.
b. These items assist in the task of predicting the timing and amount of future cash
flows.
c. Neither a. nor b.
d. Both a. and b.
8. On November 1, 2016, Kris Co. paid $7,200 to for a one year insurance policy on
its equipment. With respect to this policy, what amounts should Kris report for
prepaid insurance and insurance expense in its December 31, 2016, financial
statements?
Prepaid Insurance Insurance Expense
a. $6,000 $1,200
b. $7,200 $0
c. $0 $7,200
d. $0 $0
9. Other comprehensive income components:
a. Are shown net of their related tax effects.
b. Include all changes in equity that do not affect the income statement.
c. Include realized gains and losses.
d. Eliminate the effects that unrealized gains and losses have on the financial
statements.
10. A debit
a. increases Accounts Payable.
b. increases Cost of Goods Sold.
c. decreases Accounts Receivable.
d. decreases Equipment.
QUIZ ANSWERS:
1. C. Revenue should be recognized over the life of the contract.
2. B. The matching principle matches the recognition of expenses to the same period
as the revenue was recognized.
3. D. Income or loss from the disposal of a component of a business should be
reported as a discontinued operation.
4. A. If a company adopts a new FASB standard, it should be reported as a change in
accounting principle.
5. B. The use of accounting flexibility to meet earnings benchmarks is known as
earnings management.
6. D. All of these options can lead to accounting errors or irregularities.

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7. D. The purpose of reporting nonrecurring items, net of related income taxes, below
income from continuing operations is to help explain deviations in current year net
income from past trends, and to assist in the task of predicting the timing and amount
of future cash flows.
8. C. Insurance expense should be $600 per month. As of December 31, there are still
10 months of coverage remaining. Therefore, $6,000 is the balance in prepaid
insurance. Insurance expense is $600 per month for 2 months, or $1,200.
9. A. Comprehensive income components are shown net of their related tax effects.
10. B. Debits increase assets, expenses and losses.
RECOMMENDED FIGURES AND EXHIBITS
1. Figure 2.1—Canterbury Publishing Comparison of Accrual-Based Earnings and
Operating Cash Flow
2. Figure 2.2— Proportion of firms reporting nonrecurring items (2002–2014)
3. Exhibit 2.6—Types of Accounting Changes

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CHAPTER 3
REVENUE RECOGNITION
CHAPTER OVERVIEW
Revenue recognition rules are transitioning from a patchwork of guidance that addressed
specific issues individually. Often the issues addressed were related to a specific industry or
the quirks of a particular type of transaction. Beginning in 2018 for calendar-year firms, the
new ASC Topic 606 will take effect. It provides a single model that is to be applied by all
firms in determining when revenue may be recognized.
The model provides a five-step method for evaluating contracts with customers to deter-
mine when revenue may be recognized.
1. Identify the contract(s) with a customer
2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations in the contract
5. Recognize revenue when (or as) the entity satisfies a performance obligation
Contracts with customers give rise to performance obligations, representing the goods or
services a firm has obligated itself to provide. Transaction prices are allocated to
performance obligations and revenue is recognized when (or as) the performance obligations
are satisfied.
Until ASC Topic 606 becomes effective, for fiscal years beginning after December 15,
2017, existing guidance remains in effect. Under existing guidance, revenue is recognized
when the earnings process is substantially complete and collection is reasonably assured. In
some circumstances, such as for long-term construction contracts, it is sometimes appropriate
to recognize revenue as work progresses. When collection is highly uncertain, the installment
method is used to recognize revenue.
For many firms, the financial statement effects of changing to the new standard will not
be material, although the changeover in the rules will certainly affect some financial
statements. Until firms begin to disclose their anticipated financial statement effects, it is
difficult to quantify what those will be.
Under both the existing rules and ASC Topic 606, revenue recognition can be subjective.
Financial statement users should be cognizant of how firms apply revenue recognition
standards.
CHAPTER OUTLINE
I. The Five-Step Revenue Recognition Model
A. Step 1: Identify the Contract(s) with a Customer
B. Step 2: Identify the Performance Obligations in the Contract
C. Step 3: Determine the Transaction Price
D. Step 4: Allocate the Transaction Price to the Performance Obligations in
the Contract
E. Step 5: Recognize Revenue When (or as) the Entity Satisfies a
Performance Obligation
F. Practical Expedients in Applying the Model
G. Applying the Model to Contract Modifications

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Teaching Tip: Consulting firms use the percentage-of-completion method for fixed
price, fixed period contracts. The Information Technology Professional Services
sector, for example, uses this method to record approximately 30 % of its revenues.
II. Contract Acquisition and Fulfillment Costs
A. Amortization and Impairment
III. Disclosure Requirements
A. Disaggregated Revenue
B. Contract Balances
C. Performance Obligations and Significant Judgments
Teaching Tip: The notes to the financial statements provide important useful
information for financial statement users. The new revenue recognition standard
requires extensive disclosures.
IV. Effective Dates and Transition
A. Retrospective Approach
B. Cumulative Effect Approach
V. Financial Statement Effects of New Standard
VI. Global Vantage Point
A. The Meaning of Collectibility
B. Reversals of Impairments
C. Disclosure Requirements
VII. Revenue Recognition Prior to the Effective Date of ASC Topic 606
A. Long-Term Construction Contracts
B. Installment Sales Method
C. Franchise Sales
D. Sales with Right of Return
E. Bundled (Multiple-Element) Sales
CHAPTER QUIZ
1. The new ASC Topic 606 provides a model for revenue recognition that includes
a. Five steps.
b. Four steps.
c. Three steps.
d. Two steps.
2. Under ASC Topic 606 for revenue recognition, which of the following statements is
not accurate regarding performance obligations?
a. Firms must disclose warranties provided.
b. Firms must disclose qualitative information about their performance obligations.
c. Firms are not required to disclose any judgments used to apply the standard.
d. Firms must disclose the aggregate amount of the transaction price allocated to
unsatisfied performance obligations.
3. Microtex Corporation sells computers and accessories. The company’s newest
computer has a wholesale price of $100. In addition, the company sells carrying cases
($25), hard drives ($15), and earbuds ($10) made especially for this computer. During

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the holiday season, Microtex offers the computer, carrying case, hard drive and
earbuds as a package for $120. For each package sold, the transaction price allocated
to the computer is
a. $0.
b. $80.
c. $100.
d. $120
4. Under ASC Topic 606 for revenue recognition, a performance obligation is
considered satisfied when control over the goods and services is transferred to the
customer. Which of the following is not an indicator that control has transferred?
a. The customer has legal title of the goods.
b. The customer is legally obligated to pay for the goods or services.
c. The customer has accepted the goods and has physical possession of the goods.
d. All of these are indicators that control has transferred.
5. Under ASC Topic 606 for revenue recognition, which of the following factors is not
an indicator of the principal/agent determination?
a. Credit risk.
b. Inventory risk.
c. Shipping terms.
d. Control of prices of the goods or services.
6. Which of the following statements is not applicable to contract acquisition costs
under ASC Topic 606 guidance for revenue recognition?
a. Incremental costs of acquiring a contract must be capitalized and amortized over
the life of the contract.
b. Costs that would be incurred regardless of whether a contract is obtained are not
capitalized.
c. The capitalization requirement is subject to a practical expedient.
d. Costs must be capitalized even if the amortization period is one year or less.
7. Spalding, Inc. sells, installs and maintains computer equipment. The contract with its
customers to purchase equipment includes installation and includes a one-year
maintenance contract, renewable for up to three years. Because the useful life of the
equipment is expected to be three years, the company can reasonably expect its
customers to renew the maintenance contracts for the full three years. Spalding
records the cost of installation of the equipment as a capitalized contract and
amortizes the cost over the three-year maintenance agreement period. Because of a
defect in one of its models, Spalding anticipates that many of its customers will trade
in the model and not renew the maintenance contracts. Spalding, Inc. should
a. write down the full amount received for maintenance contracts for the full three
years.
b. write down the full amount of installation costs.
c. write down the contract asset and recognize a loss equal to the difference between
the amount of maintenance contracts expected and the carrying amount.

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d. do nothing until the customers fail to renew the maintenance contracts.
8. Which of the following statements is not true regarding ASC Topic 606?
a. Long-term construction contracts is an area where the new standard clearly differs
from existing guidance.
b. Adoption for calendar reporting entities is first required for calendar 2018.
c. Current guidance on long-term contracts gives more flexibility to firms for
determining when revenue is recognized.
d. The new standard precludes the use of percentage-of-completion method for long-
term construction contracts.
9. Assuming the requirements for recognizing revenue over time are met, and using the
percentage-of-completion method to recognize revenue, the measure of completion is
computed by dividing
a. profits earned to date by estimated total profits.
b. costs incurred to date by estimated total costs.
c. costs incurred to date by the contract price.
d. profits earned to date by the contract price.
10. Billy’s Construction entered into the following contracts with Larry’s Landscaping,
LLP: (1) construct a concrete patio, (2) plant shrubs, and (3) landscape area for a new
home construction project. Larry’s Landscaping should treat the contracts
a. as a single contract.
b. as three separate contracts.
c. as two contracts—one for hardscaping and one for landscaping.
d. None of these.
Essay Question
1. Technology companies sell software, hardware, and support in a bundled (multi-
element sales) transaction. Describe the various methods of earnings management
possible for technology companies.
QUIZ ANSWERS:
1. A. The new ASC topic 606 provides a 5-step model.
2. C. Firms are required to disclose judgments used in applying the standard.
3. B. 66.67% of the price of $120 is allocated to computer, or $80.
4. D. All of these are indicators.
5. C. Shipping terms are not indicator of principal/agent determination.
6. D. Costs may be expenses if the amortization period is one year or less.
7. C.A contract asset is written down if it is deemed to be impaired, in which case a loss is
recognized. A contract asset is impaired if the carrying amount exceeds the recoverable
amount.

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8. D. ASC Topic 606 does allow the use of percentage-of-completion method for long-
term construction contracts.
9. B. Percentage of completion is calculated as costs incurred to date divided by estimated
total costs.
10. A. Two or more contracts entered into around the same time with the same customer
should be treated as a single contract if the contracts were negotiated together and have a
single business purpose.

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