Corporate Financial Reporting Exam 1

Front 1

Transitory earnings (3 categories)

Back 1

1) Special or unusual items
2) Discontinued operations
3) Extraordinary items

Front 2

Income from continuing operations

Back 2

Normal, recurring, (presumably) more sustainable, ongoing operating activities - can include special/unusual items (infrequent gains/losses)

Front 3

Why is income from continuing operations intended to serve as the anchor for forecasting future profits?

Back 3

It summarizes the wealth effects of recurring transactions or activities that are expected to continue into the future

Front 4

Special or unusual items

Back 4

-Material events
-From continuing operations
-Either unusual or infrequent (not both)
-Disclosed as separate line item as part of Income from continuing operations

Front 5

Special or unusual items examples

Back 5

1) Write-offs of receivables, inventories, equipment leased to others, and intanglibles
2) Gains/losses from the exchange or translation of foreign currencies
3) Gains/losses from sale or abandonment of PPE
4) Special one-time charges resulting from corporate restructurings
5) Gains/losses from sale of investments

Front 6

Discontinued operations

Back 6

Operations that will not generate future cash flows

Front 7

Rules for disclosure of Discontinued operations

Back 7

-Must restate all presented periods with the discontinued operations separated out.
-Must disclose:
a) Operating income or loss of the segment from the beginning reporting date until the disposal date
b) Gain or loss from this disposal (sales price less book value).

Front 8

When are revenues recognized?

Back 8

1) Earned, meaning the seller has performed a service or conveyed an asset to the buyer;
2) Measurable (realized or relizable), meaning the value to be received for that service or asset is reasonably assured and can be measured with a high degree of reliability.

Front 9

Company must disclose discontinued operations for:

Back 9

Reportable segment
Operating segment
Reporting unit
Subsidiary
Asset group

Front 10

Extraordinary Items must be both:

Back 10

1) Unusual
The underlying event or transaction possesses a high degree of abnormality, and taking into account the environment in which the company operates, that event or transaction is unrelated to the ordinary activities of the business.
2) Infrequent
The underlying event or transaction is a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the company operates.

Front 11

To what two sources do gains/losses go?

Back 11

1) NI: Gains and losses associated with “closed” transactions flow to the income statement.
2) Equity: Unrealized gains and losses from “open” transactions flow directly to owners’ equity as “other comprehensive income”.
-count as income but no change to NI

Front 12

Other comprehensive income (5 types)

Back 12

1) Unrealized gains and losses on “available for sale” marketable securities.
2) Unrealized foreign currency translation gains and losses.
3) Some losses related to minimum pension obligations.
4) Unrealized actuarial gains and losses on pension assets and liabilities and increases (decreases) in pension obligations due to prior service cost adjustments.
5) Unrealized gains and losses associated with hedging certain risks.

Front 13

Multi-step Income Statement (7 parts)

Back 13

1) Income from Continuing Operations Before Taxes
2) Taxes
3) Income from Continuing Operations After Taxes
4) Discontinued Operations, net of tax
5) Extraordinary Items, net of tax
6) Cumulative Effect of Accounting Change, net of tax
7) Net Income

Front 14

Are dividends an expense?

Back 14

No!

Front 15

Reported EPS (5 parts)

Back 15

3) Basic/Diluted Income from Continuing Operations After Taxes
4) Discontinued Operations, net of tax
5) Extraordinary Items, net of tax
6) Cumulative Effect of Accounting Change, net of tax
7) Basic/Diluted Net Income (loss) per common share

Front 16

Percentage-of-completion method

Back 16

Revenue is recognized in proportion to the “work done” each period. (Preferred Method!!)

Front 17

Percentage of completion ratio

Back 17

Cost incurred/ Estimated total costs

Front 18

Estimated total contract profit (gross profit)

Back 18

Revenues - Estimated Total Costs (Costs to date + estimated future costs)

Front 19

Estimated profit earned to date

Back 19

Percentage of completion ratio x Estimated total contract profit (gross profit)

Front 20

Completed-contract method

Back 20

-Long-term construction projects (not the preferred method)
-postpones all revenue recognition (and expenses) until the period of project completion.

Front 21

Revenue recognition prior to sale:

Back 21

-Commodities
-Condition 1: The critical event is extraction (mining) or harvesting (agriculture), and occurs before the sale (i.e., formal transfer of title).
-Condition 2: The precise time at which measurability is satisfied is open to some dispute.

Front 22

Revenue recognition after the sale:

Back 22

-Installment sales method
-High risk of not receiving cash from the buyer (Conditions 1 and 2 are not met).
-Or there is no reasonable basis for estimating uncollectible accounts (Condition 2 is not met).
-Revenue recognition occurs as cash is collected (i.e., as installment payments are made)

Front 23

Specialized transactions: (3 types)

Back 23

1) Franchised sales
2) Sales with right of return
3) Bundled sales

Front 24

How much of the initial franchise fee should be recognized as revenue up front by the franchisor?

Back 24

Recognize revenue for the initial franchise fee only when all material services and conditions have been substantially performed by franchisor.

Front 25

When can a seller recognize revenue for sales with a right of return?

Back 25

When the amount of future returns can be reasonably estimated

Front 26

How much revenue of bundled sales should be allocated up front?

Back 26

-Allocation based on vendor-specific objective evidence of the elements’ relative fair value
-If bundle can be separated, may be over a period, as installed, delivered or completed

Front 27

The SEC says revenue is earned (critical event) and realized (measurability) when all of the following are met: (4)

Back 27

1) Pervasive evidence of an exchange agreement exists.
2) Delivery has occurred or services have been rendered.
3) The seller’s price to the buyer is fixed or determinable.
4) Collectibility is reasonably assured.

Front 28

Revenue recognition abuses: (6)

Back 28

1) Goods shipped on consignment
2) Sales with delayed delivery
3) Goods sold on lay-away
4) Non refundable up-front fees
5) Gross vs. net basis for internet resellers
6) Capacity swaps

Front 29

How are most accounting errors and irregularities corrected and disclosed once they are discovered?

Back 29

Prior period adjustment

Front 30

Which F/S are required? What if material changes?

Back 30

1) I/S
2) B/S
3) CF
If material changes: 4) SE

Front 31

What does the B/S (A=L + E) help assess? (5)

Back 31

1) Rates of Return: ROA & ROCE
2) Capital Structure: Debt vs. Equity
3) Liquidity: Cash conversion
4) Solvency: Ability to pay debt
5) Flexibility: Operating and financial

Front 32

What are the measurement methods used in the B/S? (4) How do they limit B/S use?

Back 32

1) Historical Cost (PPE)
2) Current cost - fair value (Cash)
3) Net realizable value (Net Rec.)
4) Discounted present value (LT Debt, Pension)
Limitations: apples & oranges

Front 33

What do current assets include and not include?

Back 33

Include:
1) Cash
2) ST investments
3) A/R
4) Inventories

Don't include:
1) PPE
2) Investments (LT)

Front 34

Quick Ratio

Back 34

(Cash + Mkt Sec. + A/R)/ CL

Front 35

Current Ratio

Back 35

(Cash + Mkt Sec. + A/R + Inv.)/ CL

Front 36

ROA

Back 36

EBI/ Ave assets = (NI + Int(1-t))/ Ave assets

Front 37

What does current liabilities include? (4)

Back 37

1) Notes payable
2) Current portion of LT debt
3) Acct payable
4) Accrued liabilities

Front 38

Why is the B/S important? (2)

Back 38

1) Valuation
2) Understanding a firm's business (eg Common-sized B/S fro 4 companies)

Front 39

What do footnotes include? (3) Not include?

Back 39

Include:
1) Policies
2) Subsequent events
3) Related party transactions

Don't include:
-When there is new evidence on an existing event (Restatement req.)

Front 40

Why is the statement of CF important?

Back 40

Shows if the company is supported by CF (FCF = Op - Inv - Div)

Front 41

What are the 3 activities included in the S of CF?

Back 41

1) Operating
2) Investing
3) Financing

Front 42

What does the S of CF explain? (2)

Back 42

1) Explains why a firm’s cash position changed between successive B/S dates
2) Explains why non-cash assets, liabilities, and stockholders’ equity have changed

Front 43

Operating Activities

Back 43

Cash inflows and outflows from transactions and events that affect operating income

Front 44

Investing Activities

Back 44

Cash inflows and outflows from loaning money to others, investing in securities, or in assets (e.g., equipment) used to produce goods and services.

Front 45

Financing Activities

Back 45

Cash inflows and outflows from borrowing money, selling stock, and paying dividends

Front 46

What are the tools and approaches to F/S analysis?

Back 46

1) Common size statements (Time-series analysis: the same firm over time)
2) Trend statements (Cross-sectional analysis: different firms at a single point in time)
3) Financial ratios (Benchmark comparison: using industry norms or predetermined standards)

Front 47

Operating profit margin

Back 47

EBI/ Sales

Front 48

Asset turnover

Back 48

Sales/ Ave assets

Front 49

Op Profit Margin x Asset T/O

Back 49

ROA

Front 50

Why is ROE important? (2)

Back 50

1) Represents return to shareholders
2) Leverage - using debt wisely
-Borrow when ROA (potential return) > Int (cost of capital) or ROE will decrease

Front 51

What are 3 ways to increase ROE?

Back 51

Increase:
1) Margin (NI/Sales)
2) Turnover (Sales/Assets)
3) Leverage (Assets/Equity)

Front 52

Revenue recognition prior to sale:

Back 52

-Commodities
-Condition 1: The critical event is extraction (mining) or harvesting (agriculture), and occurs before the sale (i.e., formal transfer of title).
-Condition 2: The precise time at which measurability is satisfied is open to some dispute.

Front 53

Revenue recognition after the sale:

Back 53

-Installment sales method
-High risk of not receiving cash from the buyer (Conditions 1 and 2 are not met).
-Or there is no reasonable basis for estimating uncollectible accounts (Condition 2 is not met).
-Revenue recognition occurs as cash is collected (i.e., as installment payments are made)

Front 54

Specialized transactions: (3 types)

Back 54

1) Franchised sales
2) Sales with right of return
3) Bundled sales

Front 55

How much of the initial franchise fee should be recognized as revenue up front by the franchisor?

Back 55

Recognize revenue for the initial franchise fee only when all material services and conditions have been substantially performed by franchisor.

Front 56

When can a seller recognize revenue for sales with a right of return?

Back 56

When the amount of future returns can be reasonably estimated

Front 57

"Big Bath" restructuring charges (earnings mgt, compensation)

Back 57

If already have a bad year, make it worse with write-offs to make next year better

Front 58

What measure is used most often for mgt compensation?

Back 58

Non-financial performance

Front 59

Dupont Model (simplified)

Back 59

ROE = ROS x Asset T/O x Capital Structure = Margin x T/O x Leverage

Front 60

Why do firms report EBITDA and "pro forma" (projections - past/future) even though not req by GAAP?

Back 60

-impression mgt
-help investors & analysts spot non-recurring or non-cash revenue and expense items that might otherwise be overlooked
-mislead by changing way profits are measured (transform GAAP loss into profit)
-use w/ caution!

Front 61

What is the best predictor of FCF (need for DCF analysis)?

Back 61

Earnings (though still may be good to use multiple indicators)

Front 62

PEG ratio

Back 62

P/E to growth ratio: divide P/E by expected EPS growth rate for coming year
-When PEG = 1, fair valued stock
-When PEG < 1, shares may be at bargain (undervalued stock)

Front 63

What are some cautions for using PEG?

Back 63

-Works only w/ growth companies
-Need history of earnings
-Earnings forecasts can be wildly wrong
-Hard to calculate mid-way through year

Front 64

Abnormal Earnings

Back 64

AE = Earnings - r x Capital
(Earnings above expected return of investment)
Earnings = What mgt does w/ $
r = expected return
Capital = $ investors give to mgt

Front 65

How is abnormal earnings used for valuation?

Back 65

P = BV at t=0 + Expected future abnormal earnings

Front 66

When do DCF and AE methods give the same result?

Back 66

When all dividends are assumed to be paid out

Front 67

Why are PE ratios different across industries? (3)

Back 67

1) risk
2) growth
3) quality of earnings/ acct #s

Front 68

How are PE and growth related?

Back 68

Higher PE, higher growth (lower PE considered value company)

Front 69

Financial Reporting Flexibility

Back 69

Acct methods and estimates used by company and its freedom to change them

Front 70

Types of Contracts (3)

Back 70

1) Debt covenants: Loan agreements
2) Compensation agreements
3) Regulatory: Agreements w/ agencies, partners, suppliers, distributors, customers

Front 71

What are 3 ways to motivate parties of a contract?

Back 71

1) stock based
2) accounting (eg earnings)
3) non-financial (eg customer satisfaction)

Front 72

What are examples of the affirmative parts of loan agreements/debt covenants?

Back 72

1) FS must comply w/ GAAP and be audited (mgt has flexibility) - applied to material items only
2) Maintain:
-Current Ratio > 2 (CL def by GAAP)
-Profitability > 1.5
-Fixed Charge Coverage Ratio > 1 (def by contract)

Front 73

What are examples of the negative parts of loan agreements/debt covenants?

Back 73

1) Total indebtedness (including perhaps leases)
2) How funds are used:
-payment of cash dividends
-stock repos
-mergers, asset sales, voluntary prepayment of debt
(Sometimes the actions are permitted, but only with prior approval by the lender)

Front 74

What are typical events of default/termination on loan agreements? (4)

Back 74

1) Failure to pay interest or principal when due
2) Covenant violation
3) Inaccuracy in representations
4) Failure to pay other debts when due

Front 75

What are the options for the lender when a debt covenant is violated?

Back 75

1) Waive
2) Renegotiate
3) Seize collateral
4) Initiate bankruptcy
(order of increasing severity of violation)

Front 76

Why do managers have strong incentives to reduce the likelihood of default on debt covenants?

Back 76

Debt covenant violations are costly

Front 77

How do mgrs reduce likelihood of default?

Back 77

1) Acct choices
-Accounting methods
-Accounting estimates
-Transaction timing

2) Discretionary accruals
- Non-cash FS adjustments

Front 78

When mgrs reduce likelihood of default, what is the LT risk?

Back 78

These maneuvers may increase earnings or improve balance sheets in the short-run, but they can mask deteriorating economic fundamentals.

Front 79

What are 3 ways to compensate mgt?

Back 79

1) Base salary - industry norms
2) Annual incentive - yearly performance-based award
3) LT incentive - yearly award in cash, stock, or stock options for multi-year performance

Front 80

What is the trend of salary as % of compensation?

Back 80

Decreasing

Front 81

Why are accounting # incentives controversial?

Back 81

1) Manipulation
2) Earnings growth doesn't always = increase in shareholder value
3) Increased ST focus

Front 82

Net realizable value of receivables

Back 82

NRV = Gross amt of rec. owned - Estimated collectibles - Est. returns & allowances

Front 83

How does GAAP req A/R shown on B/S?

Back 83

At net realizable value

Front 84

Uncollectibles

Back 84

the amount that will not be collected because customers are unable to pay

Front 85

Returns and allowances

Back 85

the amount that will not be collected because customers return the merchandise or are allowed a reduction in the amount owed

Front 86

What are the 5 journal entries associated with A/R?

Back 86

1) D: A/R, C: Sales
2) D: Cash, C: A/R
3) D: Exp, C: Allowance for BD
4) D: Allowance for BD, C: A/R
5) D: A/R, C: Allowance; D: Cash, C: A/R

Front 87

What is the impact of write-offs?

Back 87

-No impact on Current Ratio
-Reduce asset and contra-asset accts
-if WO > allowance, must change estimation

Front 88

What happens if a WO comes back and pays (reverse WO)? "recoveries on loans previously charged off"

Back 88

D: A/R, C: Allowance
D: Cash, C: A/R

Front 89

When does a WO occur?

Back 89

When an actual acct is uncollectible?

Front 90

What is the JE for EOY estimation of Allowance for BD?

Back 90

D: Exp, C: Allowance

Front 91

What is the JE for deductions from Allowance?

Back 91

D: Allowance, C: A/R

Front 92

To what does A/R, net refer?

Back 92

Net of bad debt allowance

Front 93

What are 2 approaches to estimating A/R and Bad debt expense?

Back 93

1) Sales Revenue (Bad debt = %Sales)
2) Gross Receivable (%Outstanding Rec.)

Front 94

"Channel stuffing"

Back 94

Create fictional sales & write off later (sell w/ understanding of returning)

Front 95

Why might Rec. grow faster than Sales?

Back 95

1) Change in credit policy or credit worthiness of customers
2) Channel stuffing
3) Bill & hold (sales booked too early)

Front 96

What are 2 ways to accelerate cash collections?

Back 96

1) Sale of Rec. (Factoring) - off B/S
2) Collateralized borrowings - on B/S

Front 97

What are the JE and activities associated with Factoring and Collateralized borrowings?

Back 97

Factoring:
D: Cash, C: A/R - operating CF

Borrowings:
D: Cash, C: Liab - financing

Front 98

Why might a firm want to accelerate cash collections?

Back 98

1) to avoid processing and collection costs
2) because of a cash flow imbalance between supplier payments and receivable collections
3) to fund an immediate cash need.

Front 99

Are gains/losses recognized in income for Sale of Rec. or Borrowings?

Back 99

Yes for Sale of Rec, No for Borrowings

Front 100

Is control surrendered for Sale of Rec. or Borrowings?

Back 100

Yes for Sale of Rec, No for Borrowings

Front 101

What is the JE for Discounted Notes?

Back 101

D: Cash, Prepaid Int., C: Note rec.

Front 102

Special purpose entities (SPEs)

Back 102

A trust or corporation that is legally distinct from the transferor (e.g., bank)

Front 103

Who do SPEs protect?

Back 103

It protects investors who loaned money.

Front 104

Why do transferors like to create SPEs?

Back 104

Under some circumstances, it also allows the transferor to receive favorable (off balance sheet) treatment of the transaction - called Qualifying SPE (QSPE) when don't have to consolidate F/S

Front 105

What does "with or without recourse" mean?

Back 105

"with recourse" - footnote disclosure of contingent liab.
"without recourse" - no footnote req.

Front 106

Does GAAP require the cost flow assumption to correspond to the actual physical flow of inventory?

Back 106

No

Front 107

When are goods recorded as inventory?

Back 107

When goods are legally owned

Front 108

Should consignment goods be recorded as inventory for the consignee?

Back 108

No

Front 109

LIFO Reserve

Back 109

Excess of FIFO

Front 110

What is the adjusting entry used with LIFO when LIFO Reserve increases?

Back 110

D: COGS, C: LIFO Reserve

Front 111

What is the adjusting entry used with LIFO when LIFO Reserve decreases (LIFO liquidation)?

Back 111

D: LIFO Reserve, C: COGS

Front 112

What are the additional taxes with LIFO liquidation?

Back 112

Taxes = (Change in LIFO Reserve)(tax rate)

Front 113

How to compare companies with different methods (LIFO/FIFO)?

Back 113

1) COGS - Change in LIFO Res.
2) Inventory + LIFO Res. for ea. yr

Front 114

Why do companies not use LIFO?

Back 114

The estimated tax savings is too small.

Business cycles may cause extreme fluctuations in physical inventory levels.

*The rate of inventory obsolescence is high.

Managers may want to avoid reporting lower profits because they believe doing so will lead to:
Lower stock price
Lower compensation from earnings-based bonuses
Loan covenant violations

*Small firms may not find LIFO economical because of high record-keeping costs

Theoretical: BS #s become distorted