Additional Reporting Issues Fundamentals of Intermediate Accounting Weygandt, Kieso and Warfield Chapter 17: Additional Reporting Issues Prepared by Bonnie Harrison, College of Southern Maryland LaPlata, Maryland

Chapter 17 Additional Reporting Issues After studying this chapter, you should be able to: Describe various accounting changes. Understand how to account for cumulative-effect accounting changes. Understand how to account for retroactive accounting changes. Describe the accounting for changes of estimates. 1 2 3 4

Chapter 17 Additional Reporting Issues After studying this chapter, you should be able to: Describe the accounting for correction of errors. Compute earnings per share in a simple capital structure. Compute earnings per share in a complex capital structure. 5 6 7

Types of Accounting Changes The types of accounting changes are: Changes in Accounting Principle Changes in Accounting Estimates Errors in Financial Statements

Changes in Accounting Principle A change in principle involves a change from one generally accepted principle to another A change in principle does not result from the adoption of a new accounting principle A change to a generally accepted principle (from an incorrect principle) is a correction of an error

Changes in Accounting Principle Changes in accounting principle are classified into: Cumulative-effect type of accounting change Retroactive-effect type of accounting change Change to the LIFO method of inventory

Cumulative-Effect Type of Accounting Change The catch up method should be used to account for these changes Financial statements for prior periods are not restated For all prior periods, the following items are shown on an as-if basis (as if the new principle had been applied): income before extraordinary items net income

Cumulative-Effect Type of Accounting Change The adjusting entry is effective as of the beginning of the year Pro forma information is shown only as supplementary information Such information may be reported: in the income statement in a separate schedule in the notes to the financial statements

Cumulative Effect: Example XYZ company changes from the sum-of-the-years’ digits method to the straight line method of depreciation. The depreciation amounts are: Year SYD ST.LINE 2002 $15,000 $8,000 2003 $14,000 $8,000 The company’s tax rate is 40% Record the change as of the beginning of 2004

Cumulative Effect: Example Year SYD SL Diff Tax Effect 2002 $15,000 $8,000 $7,000 $2,800 2003 $14,000 $8,000 $6,000 $2,400 -------- -------- $13,000 $5,200 -------- -------- Tax effect is the difference times the tax rate

Cumulative Effect: Example Journal Entry: Accumulated Depreciation $13,000 Deferred Tax Asset $5,200 Cumulative Effect of Change in Principle $7,800 The debit to accumulated depreciation is the excess of SYD over the straight line basis The credit to Cumulative Effect is the income effect (net of tax effect)

Income Statement Presentation The following information must be presented in whole dollar amounts and as per share amounts: Income before Extraordinary Item and Cumulative Effect of Change :$ XXX Extraordinary Item (Net of Tax) :$ XX Cumulative Effect on Prior Years of Retroactive Application :$ XX Net Income :$ XX

Retroactive-Effect Type of Accounting Change The cumulative effect of the new method at the beginning of the period is determined Prior period statements are recast based on the new principle Any cumulative effect of prior periods is adjusted to the beginning retained earnings balance

Retroactive-Effect Type of Accounting Change The five situations requiring restatement of all prior period statements are: A change from the LIFO inventory method to another method A change in the method of accounting for long term construction type contracts A change from or to the full cost method in extractive industries Issue of financials to obtain first time financing A pronouncement recommending retroactive adjustment

Retained Earnings Presentation Retained Earnings account is shown as follows: Balance at beginning of year :$ XXX Adjustment for the Cumulative Effect on Prior Years :$ XX Balance at beginning (as adjusted) :$ XX Net Income :$ XXX Balance at end of year :$ XXX

Reporting a Change in Estimate Changes in estimates are accounted for on a prospective basis Such changes are viewed as normal, recurrent adjustments When uncertainty exists as to whether a change in principle or a change in estimate has occurred: the change should be treated as a change in estimate Estimates that are later determined to be incorrect should be corrected as changes in estimates Examples of changes in estimates involve: inventory obsolescence; salvage values of assets, uncollectible receivables, liability for warranties and taxes

When is a Change in Accounting Principle Appropriate? Changes are appropriate when the changed principle is preferable to the existing accounting principle The changed principle should result in improved financial reporting A change is considered preferable if a FASB standard: creates a new accounting principle, or expresses preference for a new principle, or rejects a specific accounting principle

Reporting the Correction of an Error Corrections are treated as prior period adjustments to retained earnings for the earliest period being reported Examples of accounting errors are: A change from an accounting principle that is not generally accepted to one that is accepted Mathematical errors Changes in estimates that were not prepared in good faith A failure to properly accrue or defer expenses or revenues A misapplication or omission of relevant facts Incorrect classification of cost as expense or asset

Earnings Per Share EPS indicates the income earned by each share of common stock. Reported only for common stock. Dilution of EPS means reduction in EPS. Reduction in EPS results from potential conversion of dilutive securities into common stock. Shareholders want to know the extent of reduction in EPS, if dilution takes place.

E.P.S BASIC E.P.S: NET INCOME - PREFERRED DIVIDEND ------------------------------------------------------------- WEIGHT.AVERAGE OUTSTANDING. COMMON SHARES

Basic EPS Computations: Example Given: Jan 1: 500,000 shares outstanding. May 1: Issued 84,000 shares. Sept 1: Reacquired 42,000 shares. Nov 1: Issued 36,000 shares. N.Inc [to common stock]: $654,000. Determine the earnings per share.

Basic EPS Computations: Example Jan 1: 500,000 * 4/12 = 166,667 May: 584,000 * 4/12 = 194,666 Sept 1: 542,000 * 2/12 = 90,333 Nov 1: 578,000 * 2/12 = 96,334 Total W.Avg.shares 548,000 Earnings per Share = $654,000 / 548,000 shares = $1.19

Stock Dividends and Splits Stock dividends and stock splits require restatement of weighted shares outstanding before the dividend or split. Stock dividends or splits during the year are deemed to have been outstanding since the beginning of the year. Stock dividends or splits after end of the year but before issue of the financials are likewise deemed to be outstanding since the beginning of the year.

What is “DILUTION?” “DILUTION” is the reduction in E.P.S, if: securities, potentially convertible into common stock, are converted [assumed at beginning of the year]. Two EPS amounts are important: Basic and Diluted

Complex Capital Structures Complex structures have convertible securities, options, warrants, or other rights that reduce earnings per share. Only securities that reduce earnings per share (dilutive) are considered. Securities that increase earnings per share (antidilutive) are ignored.

Diluted Earnings per Share: Methods The dilutive effect of convertible securities is measured by the if-converted method The dilutive effect of options and warrants is measured by the treasury stock method For computing dilution, the rate of conversion most advantageous to the security holder is used (maximum dilutive conversion rate)

The If-Converted Method The conversion of the securities into common stock is assumed to occur at the beginning of the year The related interest effect (net of tax) is removed from net income The weighted average number of shares is increased by the additional common shares assumed issued (at the beginning)

The Treasury Stock Method Options and warrants (and their equivalents) are included in EPS computations Options and warrants are assumed exercised at the beginning of the year The proceeds from the exercise of options are assumed used to buy back common shares The exercise price per share must be less than the market price per share for dilution to occur

Options and Warrants: Treasury Stock Method Given: Exercise price of an option : [for one share of stock] $ 10 Market price of one share at Exercise date: $ 40 Options deemed exercised: 1,000 Compute the number of weighted shares for determining diluted earnings per share

Options and Warrants: Treasury Stock Method Total proceeds from exercise: $10,000 Shares assumed issued upon exercise: 1,000 Assumed reacquisition of shares: 250 DILUTION: 1,000 - 250 = 750 SHARES (increase in outstanding shares)

Earnings per Share: Simple Capital Structures - Summary Single Presentation of EPS 1 Net Income less Preferred Dividends 2 Weighted Average Number of Common Shares Outstanding 3 EPS = Result in Step 2 Result in Step 3 4

Earnings per Share: Complex Structures - Summary Dual EPS Presentation Basic EPS Diluted EPS Dilutive Convertibles Dilutive Options and Warrants Dilutive Contingent Issues Net Income adjusted for interest (net of tax) and preferred dividends ------------------------------------------ Weighted average number of common shares assuming maximum dilution

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