Chapter 24: Full Disclosure in Financial Reporting.

1.Review the full disclosure principle and describe problems of implementation. 2.Explain the use of notes in financial statement preparation. 3.Describe the disclosure requirements for major segments of a business. 4.Describe the accounting problems associated with interim reporting. After studying this chapter, you should be able to: Chapter 24: Full Disclosure in Financial Reporting

5.Identify the major disclosures found in the auditor’s report. 6.Understand management’s responsibilities for financials. 7.Identify issues related to financial forecasts and projections. 8.Describe the profession’s response to fraudulent financial reporting. Chapter 24: Full Disclosure in Financial Reporting

The full disclosure principle calls for financial reporting of significant facts affecting the judgment of an informed reader. Two problems of implementing: 1.costs of disclosure 2.information overload The Full Disclosure Principle

Types of Financial Information

Reasons for increasing reporting requirements: Complexity of the business environment (derivatives, business combinations, pensions, stock options) Necessity for timely information (interim data, forecasts) Accounting used as a control and monitoring device Financial Reporting Scandals Increase in Reporting Requirements

1.Notes amplify or explain items presented in the body of the financial statements. 2.A statement that identifies the accounting policies of the entity must be disclosed (Summary of Significant Accounting Policies). 3.Some common notes are: Inventory Deferred taxes PPE Contingencies and commitments Changes in accounting policies Notes to the Financial Statements

(Transactions not carried out at arm’s-length) Required disclosures: The nature of the relationship A description of the transactions The dollar amounts of transactions Amounts due from or due to related parties at thebalance sheet date Disclosure of Related Party Transactions

Notes to the financial statements must explain any significant financial events that occurred after the balance sheet date, but before the issuance of the financial statements. Financial statement periodPost-balance sheet events Balance sheet date Issue date Post-Balance Sheet Events (Subsequent Events)

1.Events that provide additional evidence about conditions that existed at the balance sheet date and therefore require F/S adjustments. e.g. Litigation, bad debt expense, warranty expense Two types of post-balance sheet events require action

2. Events that arose subsequent to the balance sheet date: No F/S Adjustments Note Disclosure Required e.g. Sale of stocks or bonds, business combination, loss on note receivable created after balance sheet date Two types of post-balance sheet events require action

Investors need information regarding income statement, balance sheet, and cash flow statement. Investors also need information about segments to assess profitability. Segmented information could harm reporting firms (disclosure of data useful to competitors). Reporting by Conglomerates

Provide information about:  different types of business activities  different economic environments in which the entities operate. Objectives of Segment Reporting

An operating segment is a component that: engages in business activities that earn revenues & incur expenses, is reviewed by the company’s chief operating officer; and produces discrete financial information from the internal financial reporting system. Identifying Operating Segments

An operating segment is identified as a reportable segment if it satisfies one or more of the following criteria : 1.revenue criterion 2.profit or loss criterion 3.identifiable assets criterion Reportable Segments

Segment revenue Segment profit or loss Identifiable assets External & internal revenue ≥ 10 percent of the combined revenue of all operating segments ≥ 10 percent in absolute amount of the greater of: the combined profit of all operating segments not showing a loss, or the combined loss of all operating segments reporting a loss ≥ 10 percent of the combined assets of all operating segments CriterionThresholds Reportable Segments

Segment Disclosure Sufficiency: Disclosed segment results must be ≥ 75% of the combined external revenues for entire company Prevent Information Overload: FASB established an upper limit of ten disclosed segments Additional Segment Guidelines

General information about its operating segments Segment profit and loss information Segment assets Reconciliation of segment revenues, profits and losses, and segment assets to totals for the entire company Information about products and services Information about geographical areas Major customers Required Segmented Disclosures

Integral View- Interim report is an integral part of the annual report. Discrete View- Each interim report is treated as a separate accounting period. Report accounting transactions as they occur (like in the annual report) Companies often use integral approach for some expenses & discrete approach for others Two Interim Reporting Approaches

Integral View- Interim report is an integral part of the annual report (FASB preferred). Integral view can make Interim F/S data more useful when a company has a seasonal business (e.g. Christmas tree grower). Fixed expenses are assigned to parts of a year on the basis of sales volume or some other activity. Projection of annual results by multiplying a given quarter’s results by four can be misleading for seasonal companies without integral view adjustments. Interim Reporting: Integral View

Discrete View- Each interim report is treated as a separate accounting period. Report accounting transactions as they occur (like in the annual report). Fixed expenses are treated as period costs and expensed as incurred. Interim Reporting: Discrete View

Companies should use the same inventory methods as used in the annual report. Exceptions: May use Gross Profit Method to estimate EI for Interim Reporting When LIFO inventory is liquidated but is expected to be replaced by year end, COGS is based on expected replacement cost Should not defer inventory market declines beyond the interim period unless no loss is expected for the fiscal year Interim Reporting Inventory Requirements

Expenses subject to year-end adjustments such as bad debts and pension costs should be allocated to interim periods Income taxes are progressive but should be estimated using estimated annual effective rate Extraordinary items should be recognized as incurred—no allocation to other periods. Cumulative Effect of change in accounting principle should be reported only in the first quarter regardless of when adopted Earnings per share should be computed as a stand-alone period Problems of Interim Reporting

whether the financial statements are in conformity with U.S. GAAP circumstances in which U.S. GAAP have not been consistently applied whether disclosures in financial statements are deemed adequate an opinion on the financial statements, if possible an opinion on the effectiveness of internal controls Auditor’s Reports Must Include

Unqualified Opinion (clean opinion) May contain explanatory paragraph for: Material uncertainty such as a contingent loss that is probable but not estimable Lack of Consistency due to Change in Accounting Principle Emphasis of a Matter such as related party transactions Auditor’s Opinion

Qualified Opinion contains Exceptions that are not large enough to warrant an Adverse opinion The financial statements present fairly, except for, … Scope of auditor’s examination is limited Statements not fairly presented because: Lack of GAAP conformity Inadequate disclosure Auditor’s Opinion

Adverse Opinion: Exceptions are too material to justify a Qualified opinion. The financial statements taken as a whole are Not presented in accordance with U.S. GAAP. Adverse opinions are rare. Auditor’s Opinion

Disclaimer of an Opinion: Auditor has insufficient information to render an opinion on the financial statements. Must expressly state that no opinion can be expressed. Auditor’s Opinion

Management’s Discussion and Analysis covers three aspects of an enterprise 1.Liquidity 2.Capital resources 3.Results of operations Requires management to highlight: favorable or unfavorable trends significant events and uncertainties that affect the three aspects Increased SEC scrutiny of MD&A Management’s Report

Investors and Creditors need and want more and better information about corporate expectations. The disclosures take one of two forms: 1.Financial forecast 2.Financial projection Financial Forecasts and Projections

Financial Forecast of an entity’s expected financial position, results of operations, and cash flows. Forecast is based on assumptions and conditions expected to exist Therefore, a forecast projects financial information that management expects to occur Financial Forecasts and Projections

Financial Projection is based on hypothetical assumptions that might take place. Projection is based on hypothetical assumptions and conditions that might exist Therefore, a projection provides financial information about what might happen, Not what is expected to happen Financial Forecasts and Projections

1.AICPA is concerned about potential liability associated with forward-looking information. SEC (1979) & Congress (1995) provided “safe harbor” rules intended to protect companies when forward- looking data is released. However, this has not prevented lawsuits. 2.Accountants must provide a summary of significant assumptions used to prepare the forecast or projection. 3.AICPA provides guidelines for presentation of such information. AICPA Position on Financial Forecasts and Projections

Corporations can reach more users by the internet Internet reporting can make traditional reports more timely & useful Concern about security on the internet (hackers) Electronic filing through EDGAR is publicly available ( Internet Financial Reporting

Defined as “intentional or reckless conduct, whether act or omission, that results in materially misleading financial statements.” Could be misapplication of accounting principles or failure to properly disclose material items Enron, Worldcom, HealthSouth, etc. Fraudulent Financial Reporting

Impacted by internal and external environments Opportunities increase in certain situations: 1.Weak board of directors or audit committee 2.Weak internal controls (SOX 404 should help) 3.Unusual or complex transactions 4.Accounting issues requiring significant subjective judgments 5.Ineffective internal audit function Causes of Fraudulent Financial Reporting