financial statement influences chapter 6. chapter 6 objectives indicate how judgment influences...

FINANCIAL FINANCIAL STATEMENT STATEMENT INFLUENCESINFLUENCES

Chapter 6Chapter 6

CHAPTER 6 OBJECTIVESCHAPTER 6 OBJECTIVES

Indicate how judgment influences Indicate how judgment influences financial statement disclosures.financial statement disclosures.

Distinguish between revenue and capital Distinguish between revenue and capital expenditures; product and period costs; expenditures; product and period costs; fixed and variable costs; and controllable fixed and variable costs; and controllable and uncontrollable costs. and uncontrollable costs.

Determine how various cost classifications Determine how various cost classifications affect financial statement analysis.affect financial statement analysis.

CHAPTER 6 OBJECTIVES CHAPTER 6 OBJECTIVES (CONT.)(CONT.)

Describe how managerial choices Describe how managerial choices affect reported numbers and discuss affect reported numbers and discuss ways to validate the integrity of those ways to validate the integrity of those choiceschoices

Articulate the value of a standard Articulate the value of a standard unqualified audit report to analysis. unqualified audit report to analysis. Understand why adverse reports, Understand why adverse reports, disclaimers of opinions, and going disclaimers of opinions, and going concern questions limit analysis. concern questions limit analysis.

FINANCIAL REPORTING FINANCIAL REPORTING JUDGMENTJUDGMENT

Judgments related to financial reporting Judgments related to financial reporting inputsinputs Generally accepted accounting principles Generally accepted accounting principles

(GAAP)(GAAP) Regulation by the Securities and Exchange Regulation by the Securities and Exchange

Commission (SEC)Commission (SEC) Managerial choices about alternative Managerial choices about alternative

accounting methodsaccounting methods Nominal dollar concept of capital Nominal dollar concept of capital

maintenancemaintenance

FINANCIAL REPORTING FINANCIAL REPORTING JUDGMENT (CONT.)JUDGMENT (CONT.)

Judgment related to financial Judgment related to financial statement analysisstatement analysis Analytical judgment—the ability to Analytical judgment—the ability to

reach informed opinions about reach informed opinions about financial statements and related financial statements and related disclosuresdisclosures

Requires a logical interpretation of Requires a logical interpretation of economic realityeconomic reality

BASIC COST BASIC COST CONSIDERATIONSCONSIDERATIONS

Economic sacrifice made to Economic sacrifice made to acquire something of value; assists acquire something of value; assists in wealth maximization; and in wealth maximization; and disclosures depend on GAAP disclosures depend on GAAP (revenue versus capital (revenue versus capital expenditures) and industry (e.g., expenditures) and industry (e.g., manufacturing versus retail manufacturing versus retail businesses) businesses)

BASIC COST BASIC COST CONSIDERATIONSCONSIDERATIONS (CONT.) (CONT.)

Revenue expendituresRevenue expenditures Costs that produce revenues in the current Costs that produce revenues in the current

reporting periodreporting period Treated as an expense on the income statementTreated as an expense on the income statement

Capital (asset) expendituresCapital (asset) expenditures Costs that produce revenues in the current and Costs that produce revenues in the current and

future reporting periodsfuture reporting periods Treated initially as an asset on the balance sheetTreated initially as an asset on the balance sheet Expensed in a systematic manner as a portion of Expensed in a systematic manner as a portion of

the asset is used in generating periodic revenuesthe asset is used in generating periodic revenues


Capital and revenue expendituresCapital and revenue expenditures Required disclosures sometimes Required disclosures sometimes

deviates from theoretical basis (e.g., deviates from theoretical basis (e.g., reporting research and development reporting research and development costs as a revenue expenditure)costs as a revenue expenditure)

Managerial behavior sometimes Managerial behavior sometimes influences disclosures (e.g., influences disclosures (e.g., adjustment of lease terms so that adjustment of lease terms so that lessee reports leased assets as lessee reports leased assets as revenue expenditures)revenue expenditures)


Product and period costs (Exhibit Product and period costs (Exhibit 6-1)6-1) Product costs—inventory-related Product costs—inventory-related

costs, reported as capital costs, reported as capital expendituresexpenditures

Period costs—noninventoried costs, Period costs—noninventoried costs, reported as revenue expendituresreported as revenue expenditures


Industry influences reporting for certain Industry influences reporting for certain product and period costsproduct and period costs Merchants have only one type of inventory: Merchants have only one type of inventory:

finished goodsfinished goods Manufacturers have three types: raw materials, Manufacturers have three types: raw materials,

work in process, and finished goodswork in process, and finished goods A merchant’s costs incurred with selling inventory A merchant’s costs incurred with selling inventory

(e.g., salaries and depreciation) are period costs(e.g., salaries and depreciation) are period costs A manufacturer’s costs incurred in converting A manufacturer’s costs incurred in converting

inventory to its finished state (e.g., salaries and inventory to its finished state (e.g., salaries and depreciation) attach to the cost of the inventory depreciation) attach to the cost of the inventory and are product costs and are product costs

OTHER COST FACTORSOTHER COST FACTORS

Cost controlCost control Controllable cost—one that can be controlled Controllable cost—one that can be controlled

or heavily influenced by managerial or heavily influenced by managerial decisions; also known as discretionary costsdecisions; also known as discretionary costs

Uncontrollable cost—one that cannot be Uncontrollable cost—one that cannot be controlled in the short run; also known as a controlled in the short run; also known as a discretionary costdiscretionary cost

Managerial decisions about discretionary Managerial decisions about discretionary costs influences short and long-term costs influences short and long-term profitability (e.g., spending on research and profitability (e.g., spending on research and development or advertising)development or advertising)

OTHER COST FACTORS OTHER COST FACTORS (CONT.)(CONT.)

Cost behaviorCost behavior Fixed costs—dollar amount remains Fixed costs—dollar amount remains

constant in total, regardless of sales constant in total, regardless of sales level; cost per unit is inversely related level; cost per unit is inversely related to sales volumeto sales volume

Variable costs—dollar amount is Variable costs—dollar amount is constant on per unit basis; total costs constant on per unit basis; total costs change in direct proportion to change in direct proportion to changes in sales volumechanges in sales volume


Breakeven point—activity level where Breakeven point—activity level where revenues equal total fixed and variable costsrevenues equal total fixed and variable costs Capital intensive industries tend to have a higher Capital intensive industries tend to have a higher

breakeven point than labor intensive ones, but breakeven point than labor intensive ones, but they tend to reap greater profit on per unit basis they tend to reap greater profit on per unit basis once the breakeven point is surpassed.once the breakeven point is surpassed.

Investing decisions (e.g., for plant and Investing decisions (e.g., for plant and equipment) alter an entity’s breakeven point equipment) alter an entity’s breakeven point (Exhibit 6-2A and B) (Exhibit 6-2A and B)

Industry specific measures sometimes help with Industry specific measures sometimes help with cost-volume-profit analysis (e.g., the airline cost-volume-profit analysis (e.g., the airline industry’s disclosures of passenger loadindustry’s disclosures of passenger load


Cost compositionCost composition Influenced by the mix of products sold Influenced by the mix of products sold

by an entity.by an entity. Different products have different cost Different products have different cost

structures yielding different profit structures yielding different profit marginsmargins

Current product composition affects Current product composition affects net incomenet income

Changes in product composition alter Changes in product composition alter profitabilityprofitability


Income statements do not disclose Income statements do not disclose costs by level of control, behavior, costs by level of control, behavior, or composition or composition

MANAGERIAL JUDGMENTS MANAGERIAL JUDGMENTS AND ESTIMATESAND ESTIMATES

Companies should report Companies should report representationally faithful financial representationally faithful financial statements; financial reporting statements; financial reporting latitude allows reporting latitude allows reporting alternatives; aggressive alternatives; aggressive accounting or fraudulent reporting accounting or fraudulent reporting overstates income and results in a overstates income and results in a misallocation of resourcesmisallocation of resources

MANAGERIAL JUDGMENTS MANAGERIAL JUDGMENTS AND ESTIMATES (CONT.)AND ESTIMATES (CONT.)

Accounting methodsAccounting methods Primary qualitative characteristics—Primary qualitative characteristics—

relevance and reliabilityrelevance and reliability Analytical issue: companies Analytical issue: companies

sometimes must trade relevant sometimes must trade relevant disclosures for reliable ones or vice-disclosures for reliable ones or vice-versaversa


Secondary qualitative Secondary qualitative characteristics—consistency (over characteristics—consistency (over time) and comparability (among time) and comparability (among firms) in financial disclosuresfirms) in financial disclosures

Analytical issue: inconsistency or Analytical issue: inconsistency or incomparability hinder analysis; incomparability hinder analysis; data should be adjusted to insure data should be adjusted to insure valid benchmarkingvalid benchmarking


Estimation of future eventsEstimation of future events Needed to properly allocate Needed to properly allocate

capitalized costscapitalized costs Managerial judgment required in a Managerial judgment required in a

highly uncertain environment (i.e., highly uncertain environment (i.e., the future)the future)


Revenue recognition policyRevenue recognition policy Based on two factors:Based on two factors:

Revenue realization occurs when Revenue realization occurs when goods or services are exchanged for goods or services are exchanged for cash or claims to cashcash or claims to cash

Revenues are earned when an entity Revenues are earned when an entity has fulfilled its obligations and is has fulfilled its obligations and is entitled to the attendant economic entitled to the attendant economic benefitsbenefits


Revenue recognition policyRevenue recognition policy Problem—judgment is involved as to Problem—judgment is involved as to

when revenues are realized and when revenues are realized and earnedearned

Potential exists for premature Potential exists for premature revenue recognition (revenue recognition (front-endfront-end loading of revenues)loading of revenues)

Defenses—careful analysis and Defenses—careful analysis and evaluation of current informationevaluation of current information


Matching of expenses to revenuesMatching of expenses to revenues Expenses should be recognized in the Expenses should be recognized in the

period revenues are earned (i.e., matched period revenues are earned (i.e., matched against revenues or reported as incurred)against revenues or reported as incurred)

Problem—judgment is involved as to when Problem—judgment is involved as to when expenses are incurredexpenses are incurred

Potential exists for deferring expense Potential exists for deferring expense recognition (recognition (back-endback-end loading of expenses) loading of expenses)

Defenses—careful analysis and evaluation Defenses—careful analysis and evaluation of current informationof current information

AUDIT OPINIONSAUDIT OPINIONS

Independent expression of the Independent expression of the fairness of financial statements in fairness of financial statements in accordance with generally accordance with generally accepted accounting principlesaccepted accounting principles

AUDIT OPINIONS (CONT.)AUDIT OPINIONS (CONT.)

Types of audit reportsTypes of audit reports Standard unqualified report—provides Standard unqualified report—provides

greater assurance to the analyst than greater assurance to the analyst than the other types of opinions; also the other types of opinions; also known as a known as a cleanclean opinion opinion

Qualified report, due to a departure Qualified report, due to a departure from GAAPfrom GAAP

Adverse report—lack of conformity Adverse report—lack of conformity with GAAP (gross GAAP departures)with GAAP (gross GAAP departures)


Types of audit reports (cont.) Types of audit reports (cont.) Qualified report, due to a limitation or Qualified report, due to a limitation or

audit procedures (scope)audit procedures (scope) Disclaimer of report—inability to Disclaimer of report—inability to

render an opinion because sufficient render an opinion because sufficient evidence could not be obtained (gross evidence could not be obtained (gross scope limitations)scope limitations)


Other audit considerations:Other audit considerations: Explanatory language—describes the Explanatory language—describes the

circumstances why an unqualified circumstances why an unqualified opinion was not renderedopinion was not rendered

Going concern issue—auditor Going concern issue—auditor questions whether an entity can questions whether an entity can continue in the normal course of continue in the normal course of business, regardless of the type of business, regardless of the type of audit opinion they issueaudit opinion they issue

APPLE COMPUTER AND APPLE COMPUTER AND THE PC INDUSTRY THE PC INDUSTRY

PC companies reported economic PC companies reported economic events on a comparable and events on a comparable and consistent basisconsistent basis

Inventory reductions reduced Inventory reductions reduced potential issues related to cost potential issues related to cost considerationsconsiderations

APPLE COMPUTER AND APPLE COMPUTER AND THE PC INDUSTRY (CONT.)THE PC INDUSTRY (CONT.)

Research and development costs Research and development costs are significant in the industry, but are significant in the industry, but they are immediately expensed in they are immediately expensed in accordance with GAAP; the analyst accordance with GAAP; the analyst should monitor R&D spending and should monitor R&D spending and impact on incomeimpact on income

Entities received unqualified audit Entities received unqualified audit opinions during the period analyzedopinions during the period analyzed

financial statement influences chapter 6. chapter 6 objectives indicate how judgment influences...

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variable costs

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uncontrollable costs

cost factors

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industry influences

gaap revenue

financial statements