Case 5-1 Income Smoothing a.
Firstly, investors tend to invest in companies with stable earnings rather than one with volatile earnings. With stable earnings, there will be more likely an issuance of dividends and investors could easily predict the company’s future earnings compared to one with unstable earnings. With consistent earnings generated, it gives investors a secured feeling that it will again generate earnings as predicted. Confidence in the growth of rate of earnings is crucial because stable earnings growth further may increase further business prospective and are translated into higher stock and dividend returns.It is also crucial to have stable earnings as the growth in stock price is closely dependent on the growth of its earnings per share, a main indicator which investors used to invest in a company.
b. Step-1: Massaging the numbers or income smoothing Business managers can control the timing of some expenses and sales revenue to some extent and therefore boost or dampen recorded profit for the year. In this way managers ”put a thumb on the scale”, the scale being net income for the year. When managers cross the line and go too far it’s called cooking the books.
Cooking the books constitutes fraud and is probably illegal. The most common way of massaging the numbers involves the discretionary expenses of a business. Consider repair and maintenance expenses, for instance. Until the work is done, no expense is recorded. A manager can simply move back or move up the work orders for these expenditures, and thus either avoid recording some expense in this period or record more expense in the period.
In this way the manager controls the timing of these expenses. Managers control the timing of discretionary expenses, it is thought, to smooth profit from period to period.Instead of permitting the profit numbers to pop out of the process of the accounting system, and letting the chips fall where they may, managers ask the company’s controller to let them know in advance how profit for the period is shaping up, to get a preview of the final profit number for the year. Step-2: Cooking the books, is very serious stuff, and goes beyond massaging the numbers or doing some profit smoothing. It’s fundamentally different from taking advantage of discretionary expenses to give profit a boost up or a shove down. Cooking the books is not just fluffing the pillows” to make profit look a little better or worse for the period.
Cooking the books means that sales revenue is recorded when in fact no sales were made, or that actual expenses or losses during the period were not recorded. Cooking the books requires falsification of the accounting records. To put it as bluntly as I can, cooking the books constitutes fraud—the deliberate design of deceptive financial statements. CPA auditors search for any evidence fraud. But they may not find it when managers are adept at concealing the fraud. ttp://accounting-financial-tax.
com/2009/05/accounting-methods-and-quality-of-earnings/ Case 5-2 Earnings Quality a. Earnings quality refers to the ability of reported earnings to reflect the company's true earnings, as well as the usefulness of reported earnings to predict future earnings. Earnings quality also refers to the stability, persistence, and lack of variability in reported earnings. The evaluation of earnings is often difficult, because companies highlight a variety of earnings figures: revenues, operating earnings, net income, and pro forma earnings.In addition, companies often calculate these figures differently. The income statement alone is not useful in predicting future earnings.
Source: http://www. allbusiness. com/accounting-reporting/reports-statements-operating/956063-1. html#ixzz1bG3q0TaY b. Dell's (DELL) earnings of 28 cents per share (including 4 cents per share for cost reduction expenses) beat the consensus estimate of 23 cents. The earnings beat was high quality because they actually beat on revenue and gross margin, instead of simply slashing costs.
Gross margin of 18. % was up 100 basis points over last quarter: "Gross margin was 18. 7 percent of revenue as strong improvement in cost of goods sold, disciplined pricing, a sequential increase in sales from enterprise products, and a $69 million buyout of a revenue-sharing agreement by a vendor offset previously highlighted pressure from component costs, competitive pricing and revenue mix in client systems. " Operating cash flow was $1. 1 billion, and end-of-quarter cash and investments totaled $12.
7 billion, or 42% of today's market value. Based on the information for 2009.Case 5-6 Presentation of Financial Statement Information c. A full set of financial statements for a period should show: —Financial position at the end of the period —Earnings for the period —Comprehensive income for the period —Cash flows during the period —Investments by and distributions to owners during the period. Information about earnings, comprehensive income, cash flows, and transactions with owners have in common that they are different kinds of information about the effects of transactions and other events and circumstances that change assets and liabilities during a period.This Statement does not consider details of displaying those different kinds of information and does not preclude the possibility that some entities might choose to combine some of that information in a single statement.
In present practice, for example, a reconciliation of beginning and ending balances of retained earnings is sometimes appended to an income statement. General purpose financial statements, to which the objectives of financial reporting apply, are directed toward the common interest of various potential users in the ability of a business enterprise to generate favorable cash flows. General purpose financial statements are feasible only because groups of users of financial information have generally similar needs. But "general purpose" does not mean "all purpose," and financial statements do not necessarily satisfy all users equally well. 16. Each decision maker judges what accounting information is useful, and that judgment is influenced by factors such as the decisions to be made, the methods of decision making to be used, the information already possessed or obtainable from other sources, and the decision maker's capacity (alone or with professional help) to process the information.
Even users of financial statement information who make generally similar kinds of decisions differ from each other in those matters. 10 http://www. fasb. org/cs/BlobServer? blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175820899597&blobheader=application%2Fpdf FASB ASC 5-4 Current Value a. Basis of Presentation of Personal Financial Statements b.
Currently Viewing: c. 274 Personal Financial Statements d. 10 Overall e. 05 Overview and Background f.
General g. gt; Basis of Presentation of Personal Financial Statements 05-2 The primary focus of personal financial statements is a person's assets and liabilities, and the primary users of personal financial statements normally consider estimated current value information to be more relevant for their decisions than historical cost information. Lenders require estimated current value information to assess collateral, and most personal loan applications require estimated current value information.Estimated current values are required for estate, gift, and income tax planning, and estimated current value information about assets is often required in federal and state filings of candidates for public office. h. Currently Viewing: i.
274 Personal Financial Statements j. 10 Overall k. 05 Overview and Background l. General m. ; Basis of Presentation of Personal Financial Statements 05-3 This Subtopic provides guidance on how the estimated current values of assets and the estimated current amounts of liabilities are determined and applied in the preparation and presentation of personal financial statements.
74 Personal Financial Statement 10 Overall 05 Overview and Background FASB ASC 5-6 Revenue and Gains ; Revenue and Gains Currently Viewing: 605 Revenue Recognition 10 Overall 25 Recognition General ; Revenue and Gains 25-1 The recognition of revenue and gains of an entity during a period involves consideration of the following two factors, with sometimes one and sometimes the other being the more important consideration: a. Being realized or realizable. Revenue and gains generally are not ecognized until realized or realizable. Paragraph 83(a) of FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, states that revenue and gains are realized when products (goods or services), merchandise, or other assets are exchanged for cash or claims to cash.
That paragraph states that revenue and gains are realizable when related assets received or held are readily convertible to known amounts of cash or claims to cash. 605 Revenue Recognition10 Overall b. Being earned.Paragraph 83(b) of FASB Concepts Statement No.
5, Recognition and Measurement in Financial Statements of Business Enterprises, states that revenue is not recognized until earned. That paragraph states that an entity's revenue-earning activities involve delivering or producing goods, rendering services, or other activities that constitute its ongoing major or central operations, and revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues.That paragraph states that gains commonly result from transactions and other events that involve no earning process, and for recognizing gains, being earned is generally less significant than being realized or realizable. 25 RecognitionGeneral> Revenue and Gains 605 Revenue Recognition > 10 Overall > 25 Recognition 25-3 Revenue should ordinarily be accounted for at the time a transaction is completed, with appropriate provision for uncollectible accounts.Paragraph 605-10-25-1(a) states that revenue and gains generally are not recognized until being realized or realizable and until earned.
Accordingly, unless the circumstances are such that the collection of the sale price is not reasonably assured, the installment method of recognizing revenue is not acceptable. 25-4 There may be exceptional cases where receivables are collectible over an extended period of time and, because of the terms of the transactions or other conditions, there is no reasonable basis for estimating the degree of collectibility.When such circumstances exist, and as long as they exist, either the installment method or the cost recovery method of accounting may be used. As defined in paragraph 360-20-55-7 through 55-9, the installment method apportions collections received between cost recovered and profit. The apportionment is in the same ratio as total cost and total profit bear to the sales value. Under the cost recovery method, equal amounts of revenue
