Financial Reporting and Analysis 3e
INTRODUCTION
The Instructor’s Resource Manual that accompanies Financial Reporting and Analysis (third edition) by Lawrence Revsine, Daniel Collins, and W. Bruce Johnson reflects my experiences from using the first two editions of the text. During this time, I have used the text for the Intermediate Accounting I and Intermediate Accounting II courses along with other specialized course offerings at Defiance College. The text was also used for a combination course in Finance and Accounting in an International Business and Management curriculum at Dickinson College. During the summers of 2000, 2001, and 2003, I used the book and the course website to instruct a course entitled, “Financial Analysis in the European Union.” The summer study involved interviews of corporate and political leaders and analysis of annual reports to discuss economic development in the European Union. The first edition was also used as the text for a Master’s of Business and Organizational Leadership course in accounting at Defiance College.
This text could be used to instruct both the accounting process and analysis of financial statements. The website and other instructor materials provide various outlines, problems, collaborative exercises, and lists of related readings. Each chapter in this supplement has the same format in order to maximize its usefulness. The following paragraphs explain the various components for each chapter.
Each chapter begins with an overview that includes a full description of the chapter content in a few brief paragraphs. The chapter overview mirrors the summary found at the end of each chapter, highlighting the major topics in the chapter.
The next component is the chapter outline. These outlines were developed to provide a strong base for planning lectures, but they may be useful for classroom use as well. Each outline is organized by objective, follows the order of presentation used in the text, and highlights key words to improve an instructor’s ability to cross-reference the text.
Each outline is followed by a chapter quiz. While presented in multiple-choice format, the answers suggest that extensive analysis may be required to answer a question. Consistent with the approach taken in the accompanying textbook, equal emphasis is placed on problem solving and analysis. Note that significant conceptual understanding is required to solve many of the problem-type questions so that the mechanics can be de-emphasized. These questions provide instructors with questions from previous instructor manuals and new questions related to some of the changing topics in accounting.
The recommended exhibits section is a list of exhibits, figures, and tables from the textbook that may be particularly useful in facilitating presentation of the material. The suggested readings include materials that provide additional insights to instructors. Alternatively, some of the readings may be assigned for enrichment and discussion.
To assist in the adoption of this textbook, suggested course outlines for a one-semester course (45 contact hours) and a two-semester course (90 contact hours) are provided. The flexibility of this text and related materials will provide opportunities for instructors to present the “meaning behind the numbers” and to further analyze financial information to formulate a basis for business decision making.
Suggested Course Outline
45 Contact Hours
Contact
ChapterHoursAssignments
12.0P1-2,4,8;C1-3,7
21.5P2-3,5,8;C2-2,3
32.0P3-2,5,10;C3-1
42.0P4-2,6,12;C4-3,4,5
53.0P5-1,2,3,7,8;C5-1,2,3,4
62.5P6-2,3,7,8,10,13,18;C6-3,4
72.0P7-2,6,7,9;C7-2
82.0P8-3,7,9,10;C8-1,2,3
92.5P9-2,3,6,7,10,13;C9-1,2,5
102.5P10-1,5,8,13,14;C10-1,3,4
112.5P11-3,4,8,9,12,19,21,27;C11-1,5
122.5P12-2,3,5,10;C12-1,3
132.5P13-1,2,4,10,13;C13-2,5
142.5P14-1,2,4,8,9,10;C14-1,2
152.5P15-1,2,3,4,6,8,9;C15-1
162.5P16-1,5,6;C16-1,2
172.5P17-1,5,7,11;C17-1,2,6
182.5P18-4,5,8,13;C18-1,6
Exams3.0
45.0
Suggested Course Outline
90 Contact Hours
Contact
ChapterHoursAssignments
13.0P1-2,4;C1-3,7
22.5P2-3,5,8;C2-2,3
32.5P3-2,5,10;C3-1
43.0P4-2,6,12;C4-3,4,5
55.0P5-1,2,3,7,8;C5-1,2,3,4
65.0P6-2,3,7,8,10,13,18;C6-3,4
75.0P7-2,6,7,9;C7-2,4
84.0P8-5,7,9,10,15;C8-1,2,3
96.0P9-2,3,6,7,10,13;C9-1,2,5
105.0P10-1,5,8,13,14;C10-1,3,4
116.0P11-3,4,8,9,12,19,21,27;C11-1,5
126.0P12-2,3,5,9,10,11;C12-1,3,6
136.0P13-1,2,4,10,11,13;C13-2,5
146.0P14-1,2,4,8,9,10;C14-1,2,4
154.0P15-1,2,3,4,6,8,9;C15-1,5
165.0P16-1,5,6,8;C16-1,2,3
173.0P17-1,5,7,11;C17-1,2,6
184.0P18-2,4,8;C18-1,6
Exams9.0
90.0
Contents
Chapter 1The Economic and Institutional Setting for Financial Reporting 5
Chapter 2Accrual Accounting and Income Determination 15
Chapter 3Additional Topics in Income Determination 28
Chapter 4Structure of the Balance Sheet and Statement of Cash Flows 37
Chapter 5Essentials of Financial Statement Analysis 47
Chapter 6The Role of Financial Information in Contracting
Cash Flow Analysis, and Credit Risk Assessment 57
Chapter 7The Role of Financial Information in Contracting 69
Chapter 8Receivables 78
Chapter 9Inventories 87
Chapter 10Long-Lived Assets and Depreciation100
Chapter 11Financial Instruments as Liabilities108
Chapter 12Financial Reporting for Leases120
Chapter 13Income Tax Reporting131
Chapter 14Pensions and Postretirement Benefits140
Chapter 15Financial Reporting for Owners’ Equity152
Chapter 16Intercorporate Equity Investments165
Chapter 17Statement of Cash Flows174
Chapter 18Overview of International Financial
Reporting Differences and Inflation182
Financial Reporting and Analysis 3e The Economic and Institutional Setting for Financial Reporting
CHAPTER 1
THE ECONOMIC AND INSTITUTIONAL SETTING FOR FINANCIAL REPORTING
CHAPTER OVERVIEW
Financial statements contain information about a company, its economic health, and its products that help users in their decision making, and make it possible to monitor managers’ activities. Therein lies the demand for financial statements. Specifically, equity investors, analysts, and brokers use financial statements to form opinions about the value of a company as a basis for their investment decisions or recommendations to others. Creditors use financial information to assess the company’s ability to make its debt payments and comply with loan covenants. Other users that demand financial information include managers, employees, suppliers, customers, and government and regulatory agencies. Flexibility and consistency are both desired when preparing financial statements. The changing economic environment demands the revision of standards and best practices that will best serve these two diverse results.
What governs the supply of financial information? Two answers are mandatory reporting and financial reporting benefits and costs. Most companies in the U.S. and other developed countries are required to produce, distribute, and file financial reports with a governmental agency—the Securities and Exchange Commission (SEC) in the U.S.—so that interested parties can view the statements. The current environment also demands transparency in the processing and preparation of financial statements. Financial reporting benefits and costs are likely to affect accounting policies and reporting strategies. Therefore, the flexibility and discretion inherent in financial reporting standards provide managers with opportunities to shape financial statements to achieve specific reporting goals.
Users of this information that understand financial reporting, managers’ incentives, and accounting flexibility are better informed and more likely to be able to use financial statements to their advantage in the decision-making process.
CHAPTER OUTLINE
I.WorldCom Example
AThere are several “facts” to consider.
1.Your brother sends an email to you informing you that he bought 10,000 shares of WorldCom at $2 per share. The stock has dropped from a high of $64.50 per share.
- Stock analysts state that WorldCom is doing “surprisingly well despite tough times throughout the industry.”
b.The company has $2.3 billion in cash, nearly $.78 per share.
2.The first-quarter results indicate sales of $8,120 million and $843 million in pre-tax operating profits. This is down 16% and 34% but other firms in the industry are reporting steeper sales and earnings decreases.
3.The company has $104 billion in assets and $44 billion in debt, translating into $20.50 per share.
4. WorldCom’s “line costs” are holding steady while other companies line costs are
rising as a percentage of sales.
a. Does this suggest that WorldCom is adept at managing this aspect of its business?
b.Is this a warning signal of problems at the company?
5. You call your broker and find that the stock has declined to $1.75 per share in early
trading. What do you do?
Financial Reporting and Analysis 3e The Economic and Institutional Setting for Financial Reporting
B.Investors need adequate information to judge risk versus reward factors of investment alternatives.
1.A company’s financial statements are a critical source of information about the financial condition, operating results, and prospects for the future for an organization.
2.Financial statements can be used as an analytical tool, a management report card, an early
warning signal, a basis for prediction, and as a measure of accountability.
Teaching Tip: While financial statements are not as timely as press releases, they do provide an
economic history and are indispensable in developing an accurate profile of ongoing performance and prospects.
C.What happened with WorldCom?
1.WorldCom stunned investors by announcing that it intended to restate financial statements for 2001 and the first quarter of 2002.
2.An internal audit discovered $3.8 billion in improper transfers from line cost expenses to the balance sheet. Without these transfers the company would have reported a loss for 2001 and in the first quarter of 2002.
3.The stock price fell to $.06 per share.
Teaching Tip: While fraud is different than the flexibility and discretion inherent in financial reporting rules, analytical review of financial statements may help one uncover fraud.
Teaching Tip: This text does not focus on assisting readers of financial statements in detecting fraud. 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.Financial accounting information facilitates economic transactions and fosters efficient
allocation of resources.
B.Financial statements are demanded because of their value as a source of information about the
company’s performance, financial condition, and stewardship of its resources.
1.Shareholders and investors use financial information to decide on a portfolio consistent
with their individual preferences for risk, return, dividend yield, and liquidity.
a.Financial statements are crucial in fundamental analysis.
- Many analysts look beyond the financial statement numbers to the “meaning behind
the numbers,” making footnote disclosures invaluable.
2.Managers and employees use financial information to monitor contracts such as bonus
plans, profit-sharing plans, stock ownership plans, and to monitor the health of company-
sponsored pension plans along with information that will assist in making decisions concerning the allocation of limited resources.
3.Lenders and suppliers use financial information to assess the financial strength of a
business to determine whether to make a loan (or extend credit), and then the amount,
interest rate, and security (if any) that is needed.
4.Customers use financial information to monitor a supplier’s financial health as part of the
process of checking out a product and the company that stands behind it.
5.Government and regulatory agencies demand financial statement information
to assess compliance with laws and standards.
a.Taxing authorities may use financial statement information as a basis for establishing
tax policies designed to enhance social welfare.
b.As customers of businesses, government agencies may use financial statement information to settle contractual payments.
c.Regulatory intervention may be another source of demand for financial statement information.
C.The supply of financial information is guided by the costs of producing and disseminating it and the benefits it will provide to the company.
1.Voluntary disclosure occurs so long as the incremental benefits to the company from
supplying that information exceed the incremental costs of supplying that information.
a.Some users, such as creditors, may have enough bargaining power to compel
companies to deliver financial information that they need for analysis.
- Regulated financial reporting is designed to ensure that companies meet certain minimum levels of financial disclosure and transparency.
2.Disclosure Benefits: Managers have an incentive to supply the amount and type of
financial information that will enable them to raise capital on the best possible terms.
3.Disclosure Costs:
a.Costs associated with collecting, processing, and disseminating financial information can be large.
b.Competitors may use the information against the company providing the disclosure
(competitive disadvantage).
c.Litigation costs result when financial statement users initiate court actions against
the company and its management for financial misrepresentations.
d.Highly profitable—but politically vulnerable—firms may be subject to political
initiatives designed to impose “taxes” on them.
Teaching Tip:Small businesses are often subject to less comprehensive reporting requirements because of the prohibitive costs referred to in a. above. Likewise, political costs (d. above) may encourage firms to use accounting methods that appear less profitable. Much of the book is devoted to providing students with the skills necessary to undo accounting methods or to convert from one method to another so that more meaningful comparisons between companies may be made. Therefore, students gain insight into managers’ incentives and become more informed readers of financial statements.
III.A Closer Look at Professional Analysts
A.Financial statement users have diverse information needs because they face different decisions
or may use different approaches to making the same kind of decision. The conflicting desired result of flexibility and consistency may be problematic to standard setters.
B.The text focuses on analysts, defined broadly to include investors, creditors, financial
advisors, and auditors.
C.Information needs of analysts include:
1.Quarterly and annual financial statements and nonfinancial operating and performance
data.
2.Management’s analysis of financial and nonfinancial data, including reasons for change
(management discussion and analysis).
3.Information making it possible to identify future opportunities and risks.
4.Footnotes are important to analysts to obtain a transparent accounting of decision alternates for financial statement comparisons.
5.The analyst needs to be able to compare financial results of diverse companies to help
investors decide where to allocate scarce resources.
IV.The Rules of the Financial Reporting Game
A. Generally accepted accounting principles (GAAP) are a network of conventions,
rules, guidelines, and procedures.
1. Professional analysts are forward looking. GAAP reports what has occurred.
2. Therefore, analysts must first understand the accounting measurement rules used to
produce the data before extrapolating financial statement data into the future.
B.Financial statements should possess certain qualitative characteristics.
1.Financial information is relevant if it makes a difference in the decision-making process.
2.Financial information is timely if it reaches decision makers before it loses its capacity to
influence their decisions.
3.Financial information is reliable if it is reasonably free of error and bias, and truthfully
represents what it purports to represent.
4.Financial information is representationally faithful when the accounting actually represents the underlying transaction or economic event.
5.Financial information is neutral when it does not favor one set of interested parties over
another.
6.Financial information is comparable when it is measured and reported in a similar manner among different companies.
7.Financial information is consistent when the same accounting methods are used from
period to period.
Teaching Tip: Students often want to know which accounting alternative is “best.” Qualitative
trade-offs make it difficult to identify “good” accounting methods and disclosure practices. For example, market value may be relevant to the decision at hand, but reliability may be
questionable.
C.Two additional conventions affect whether financial statements are complete, understandable,
and helpful.
1.Materiality is established when an omission or misstatement is important enough that the
judgment of a reasonable person is influenced by the omission or misstatement.
2. Conservatism in accounting involves trying to ensure that business risks and
uncertainties are adequately reflected in the financial reports.
D.Where does GAAP come from?
1.The SEC has the ultimate legal authority to determine the rules to be followed in
preparing financial statements by publicly traded companies, but has largely delegated its
authority to the accounting profession’s Financial Accounting Standards Board (FASB).
2.GAAP may also evolve from accounting practices over time.
3.The Public Company Accounting Oversight Board (PCAOB) was established by the Sarbanes-Oxley Act of 2002 to provide oversight of auditing procedures.
4.Financial reporting standards outside the U.S. are determined in some countries by
professional accounting organizations, in other countries by commercial law and/or tax
law requirements, and on a worldwide basis by the International Accounting Standards
Board(IASB).
5.A convergence project has a goal of providing one set of worldwide accounting standards to reconcile the IASB standards with those of the FASB.
E.There is an adversarial nature to financial reporting.
1.Managers frequently have reasons to exploit the flexibility and discretion allowed by
accounting standards since their interests may conflict with the interests of creditors and
shareholders.
2.The flexibility of GAAP financial reporting standards provides opportunities to use
accounting “tricks” to make a company appear less risky than it really is, or to “smooth”
earnings by strategically timing the recognition of revenues and expenses.
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.
- America Online Inc. (AOL) embraces aggressive financial reporting practice.
1.There are several facts to the case.
a.This company is a global leader in the expanding market for online consumer
services, providing Internet, multimedia and other interactive services for consumers
and businesses.
b.Under its initial accounting method, if AOL spent $24 million on advertising and
free trials to lure new customers, the company would offset the cash outflow with a
corresponding increase to its deferred assets. The deferred asset would then be
gradually reduced by an annual charge to earnings, effectively spreading the cost
over the average life of a subscription (about 24 months).
c.AOL then switched accounting methods by adopting the industry practice of
recording the entire subscriber acquisition expense immediately.
d.This seemingly minor change produced a net loss of $353 million in the quarter of
the accounting change. AOL would have reported quarterly earnings of $19 million
under the old accounting method.
2.The investment community favored the new, more conservative accounting method, and
AOL shares closed $1 higher on the day of the announcement.