FINANCIAL REPORTING AND ANALYSIS

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1 <n millions) ties.' 5*;S, Expenses and Other aterials and production "arkstlrtg and administrative ' <attrch and development ^ Structuring' costs auitv income 0 5, , , FINANCIAL REPORTING AND ANALYSIS ITION Lawrence Revsine Late of Northwestern University Daniel W.Collins Henry B. Tippie Research Chair in Accounting Tippie College of Business The University of Iowa W. Bruce Johnson Sidney G. Winter Professor of Accounting Tippie College of Business The University of Iowa H. Fred Mittelstaedt PricewaterhouseCoopers Faculty Fellow Mendoza College of Business University of Notre Dame McGraw-Hill Irwin Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. Louis Bangkok Bogota Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto

2 Contents -^_ jr 5, ,1555 3, (1,717.1) Chapter I The Economic and Institutional Setting for Financial Reporting I WorldCom in May Why Financial Statements Are Important 2 Untangling the Web at WorldCom 3 Economics of Accounting Information 6 Demand for Financial Statements 7 Disclosure Incentives and the Supply of Financial Information 10 A Closer Look at Professional Analysts 13 Analysts'Decisions 14 Analysts'Information Needs 15 The Rules of the Financial Reporting Game 16 Generally Accepted Accounting Principles 17 Who Determines the Rules? 20 The Hierarchy of GAAP 21 Adversarial Nature of Financial Reporting 22 Aggressive Financial Reporting: A Case Study 24 An International Perspective 28 The March toward Convergence 31 Challenges Confronting the Analyst 31 APPENDIX: GAAP in the United States 33 Early Developments 33 Emergence of GAAP 35 Current Institutional Structure in the United States 37 International Accounting Standards 40 Chapter 2 Accrual Accounting and Income Determination 53 Example: Cash versus Accrual Income Measurement 53 Measurement of Profit Performance: Revenues and Expenses 57 Criteria for Revenue Recognition 60 Matching Expenses with Revenues 64 Income Statement Format and Classification 65 Special or Unusual Items (Item 2) 67 Discontinued Operations (Item 3) 68 Extraordinary Items (Item 4) 71 Frequency and Magnitude of Various Categories o Transitory Income Statement Items 72 Reporting Accounting Changes 73 Earnings per Share 81 Comprehensive Income 82 APPENDIX: Review of Accounting Procedures and T-Account Analysis 86 Understanding Debits and Credits 87 Adjusting Entries 89 Closing Entries 93 Chapter 3 Additional Topics in Income Determination 123 Revenue Recognition Prior to Sale 123 Percentage-of-Completion Method 123 Completed-Contract Method 128 Revenue Recognition on Commodities 129 Revenue Recognition Subsequent to Sale 133 Installment Sales Method 133 Cost Recovery Method 135 Revenue Recognition for Specialized Sales Transactions 137 Franchise Sales 137 Sales with Right of Return 140 Bundled Sales 140 xvii

3 XVIII Contents Earnings Management 143 Popular Earnings Management Devices 146 Accounting Errors, Earnings Restatements, and Prior Period Adjustments 151 Chapter 4 Structure of the Balance Sheet and Statement of Gash Flows 181 Classification Criteria and Measurement Conventions for Balance Sheet Accounts 182 Analytical Insights: Understanding the Nature of a Firm's Business 189 International Differences in Balance Sheet Presentation 191 Financial Statement Footnotes 193 Statement of Cash Flows 196 Cash Flows versus Accrual Earnings 199 Deriving Cash Flow Information 202 Chapter 5 Basic Approaches 235 Essentials of Financial Statement Analysis 235 Financial Statement Analysis and Accounting Quality 236 A Case in Point: Getting Behind the Numbers at Whole Foods Market 238 Examining Whole Foods Market's Financial Statements 239 Profitability, Competition, and Business Strategy 248 Financial Ratios and Profitability Analysis 248 ROA and Competitive Advantage 252 Return on Common Equity and Financial Leverage 255 Components of ROCE 257 Liquidity, Solvency, and Credit Analysis 259 Cash Flow Analysis 267 Financial Ratios and Default Risk 271 APPENDIX: Altman's Z-Score and Prediction of Bankruptcy 275 Chapter 6 Enterprise Valuation 298 The Role of Financial Information in Valuation and Credit Risk Assessment 297 The Discounted Free Cash Flow Approach to Equity Valuation 298 The Role of Earnings in Valuation 302 Research on Earnings and Equity Valuation 305 Sources of Variation in PIE Multiples 306 The Abnormal Earnings Approach to Equity Valuation 313 Application: Valuing a Business Opportunity 318 Earnings Surprises 320 Fair Value Accounting 323 Credit Risk Assessment 325 Traditional Lending Products 326 Credit Analysis 327 Credit Rating Agencies 329 APPENDIX A: Abnormal Earnings Valuation 333 APPENDIX B: Financial Statement Forecasts 337 Illustration of Comprehensive Financial Statement Forecasts 338 Chapter 7 The Role of Financial Information in Contracting 361 Finalizing the BookWorm Loan 362 Conflicts of Interest in Business Relationships 362 Debt Covenants in Lending Agreements 364 Affirmative Covenants, Negative Covenants, and Default Provisions 365 Mandated Accounting Changes as a Trigger of Debt Covenant Violation 368 Managers' Responses to Potential Debt Covenant Violations 369 Management Compensation 371 How Executives Are Paid 372 Proxy Statements and Executive Compensation 377 Incentives Tied to Accounting Numbers 378 Catering to Wall Street 382 Regulatory Agencies 385 Capital Requirements in the Banking Industry 386 Rate Regulation in the Electric Utilities Industry 387 Taxation 388 Analytical Insights: Identifying "Managed" Earnings 389

4 Contents XIX Chapter 8 Receivables 41 I Assessing the Net Realizable Value of Accounts Receivable 411 Estimating Uncollectibles 411 Assessing the Adequacy of the Allowance for Uncollectibles Account Balance 413 Estimating Sales Returns and Allowances 415 Analytical Insight: Do Existing Receivables Represent Real Sales? 416 Imputing Interest on Trade Notes Receivable 421 Accelerating Cash Collection: Sale of Receivables and Collateralized Borrowings 425 Sale of Receivables (Factoring) 426 Borrowing Using Receivables as Collateral 427 Ambiguities Abound: Is It a Sale or a Borrowing? 428 A Closer Look at Securitizations 429 Securitization and the 2007 Subprime Mess 433 Some Cautions for Statement Readers 434 Troubled Debt Restructuring 436 Settlement 438 Continuation with Modification of Debt Terms 439 Evaluating Troubled Debt Restructuring Rules 443 The Fair Value Option 444 APPENDIX: Time Value of Money 447 Future Value 447 Present Value 449 Present Value of an Ordinary Annuity 450 Present Value of an Annuity Due 451 Chapter.9 Inventories 469 An Overview of Inventory Accounting Issues 469 Determination of Inventory Quantities 472 Items Included in Inventory 475 Costs Included in Inventory 476 Manufacturing Costs 476 Absorption Costing versus Variable Costing 476 Mitigation of the Absorption Costing Effect 480 Vendor Allowances 480 Cost Flow Assumptions: The Concepts 481 First-In, First-Out (FIFO) Cost Flow 483 Last-In, First-Out (LIFO) Cost Flow 484 FIFO, LIFO and Inventory Holding Gains 485 The LIFO Reserve Disclosure 488 Inflation and LIFO Reserves 492 LIFO Liquidation 494 Reconciliation of Changes in LIFO Reserve 496 Improved Trend Analysis 496 The Frequency of LIFO Liquidations 498 Eliminating LIFO Ratio Distortions 499 Tax Implications of LIFO 500 Eliminating Realized Holding Gains for FIFO Firms 502 Inventory Errors 503 Analytical Insights: LIFO Dangers 504 Empirical Evidence on Inventory Policy Choices 505 APPENDIX A: Eliminating Realized Holding Gains from FIFO Income 509 APPENDIX B: Lower of Cost or Market Method 511 APPENDIX C: Dollar-Value LIFO 516 Overview of Dollar-Value LIFO 517 Chapter 10 Long-Lived Assets and Depreciation 545 Measurement of the Carrying Amount of Long-Lived Assets 546 The Approach Used by GAAP 547 Long-Lived Asset Measurement Rules llustrated 549 Financial Analysis and Fixed Asset Reporting 554 Intangible Assets 558 Intangibles Accounting under US. GAAP and IFRS: Similarities and Differences 562 Asset Impairment 563 Obligations Arising from Retiring Long-Lived Assets 566 Assets Held for Sale 567 Depreciation 568 Disposition of Long-Lived Assets 570 Financial Analysis and Depreciation Differences 571 International Perspective 575 Investment Property 576 Exchanges of Nonmonetary Assets 577 Exchanges Recorded at Book Value 579

5 XX Contents Chapter I I Financial Instruments as Liabilities 601 Debt or Equity? 603 Bonds Payable 604 Characteristics of Bond Cash Flows 604 Bonds Issued at Par 605. Bonds Issued at a Discount 606 Bonds Issued at a Premium 609 Graphic Look at Bonds 611 Book Value versus Market Value after Issuance 612 Fair Value Option 616 Managerial Incentives and Financial Reporting for Debt 621 Debt Carried at Amortized Historical Cost 621 Imputed Interest on Notes Payable 625 Analytical Insights: Future Cash Flow Effect of Debt 627 Incentives for Off-Balance-Sheet Liabilities 629 [ Hedges 632 Typical Derivative Securities and the Benefits of Hedging 632 Financial Reporting for Derivative Securities 638 Hedge Accounting 640 Fair Value Hedge Accounting 643 Cash Flow Hedge Accounting 645 Hedge Accounting for a Forecasted Transaction 647 Hedge Effectiveness 648 Contingent Liabilities 649 Measuring and Recognizing Loss Contingencies 650 Recording Gain Contingencies 652 Executory Costs 689 Residual Value Guarantees 690 Payments in Advance 692 Financial Statement Effects of Treating a Lease as a Capital Lease versus Treating It as an Operating Lease 693 Lessees' Footnote Disclosures 694 Income Adjustment 696 Balance Sheet and Ratio Effects: Capital Lease versus Operating Lease Approach 697 Lessor Accounting 699 Sales-Type and Direct Financing Leases 699 Lessors' Operating Leases 700 Distinction between Capital and Operating Leases 701 Direct Financing Lease Treatment Illustrated 703 Guaranteed versus Unguaranteed Residual Values 705 Financial Statement Effects of Direct Financing versus Operating Leases 706 Sales-Type Lease Treatment Illustrated 707 Additional Leasing Aspects 709 Sale and Leaseback 709 Other Special Lease Accounting Rules 710 Financial Reporting versus Tax Accounting for Leases 710 Lessors' Disclosures 711 Reconsideration of GAAP for Leases 712 APPENDIX: Making Balance Sheet Data Comparable by Adjusting for Off-Balance Sheet Leases 714 Chapter 13 Income Tax Reporting 739 Chapter 12 Financial Reporting for Leases 681 Evolution of Lease Accounting 681 Why Lessees Like the Operating Lease Method 683 The Securities and Exchange Commission's Initiative 684 Lessee Accounting 684 SFAS No. 13 Criteria for Capital Lease Treatment 684 Capital Lease Treatment Illustrated 686 Understanding Income Tax Reporting 740 Temporary and Permanent Differences between Book Income and Taxable Income 740 Problems Caused by Temporary Differences 742 Deferred Income Tax Accounting: Interperiod Tax Allocation 745 Deferred Income Tax Assets 748 Deferred Income Tax Asset Valuation Allowances 750 Illustration of Footnote Disclosure for Valuation Allowances 752

6 Contents XXI Deferred Income Tax Accounting When Tax Rates Change 753 Net Operating Losses: Carrybacks and Carryforwards 756 Using Footnote Disclosures to Improve Financial Analysis 758 Understanding Footnote Disclosures 758 Measuring and Reporting Uncertain Tax Positions 762 Assessing Uncertain Tax Position Related to a Permanent Difference 763 Uncertain Tax Position Related to Timing of Deductibility 764 Making Changes or Resolving Uncertain Tax Positions 765 Assessing FIN48 Disclosures and Adoption Effects 766 Extracting Analytical Insights from Footnote Disclosures 768 Using Deferred Tax Footnotes to Assess Earnings Quality 769 Using Tax Footnotes to Improve Interfirm Comparability 771 Using Income Tax Footnotes to Assess the Degree of Conservatism in Firm's Accounting Choices 774 APPENDIX: Comprehensive Interperiod Tax Allocation Problem 777 Computation of Taxable Income and Taxes Payable 778 Calculation of Change in Deferred Tax Asset and Liability Accounts 781 Calculation of Tax Expense 783 Chapter 14 Pensions and Postretirement Benefits 805 Rights and Obligations in Pension Contracts 805 Accounting Issues Related to Defined Benefit Pension Plans 808 Financial Reporting for Defined Benefit Pension Plans 809 A Simple Example: A World of Complete Certainty 810 The Real World: Uncertainty Introduces Gains and Losses 814 Journal Entries for Changes in Funded Status 822 Pension Funding Decision 824 Case Study of Pension Recognition and Disclosure- General Electric 825 Accumulated Other Comprehensive Income Disclosure and Deferred Income Taxes 834 Additional Issues in Computing Expected Return 836 Extraction of Additional Analytic Insights from Footnote Disclosures 837 Funded Status and Operating Cash Flows 840 Cash Balance Plans 841 Postretirement Benefits Other Than Pensions 842 Analytical Insights: Assessing OPEB Liability 846 Evaluation of Pension and Postretirement Benefit Financial Reporting 847 Chapter 15 Financial Reporting for Owners' Equity 873 Appropriate Income Measurement 873 What Constitutes the "Firm"? Entity View versus Proprietary View 874 Why Companies Repurchase Their Stock 876 Compliance with Contract Terms 880 Legality of Corporate Dividend Distributions 886 Earnings per Share 888 Simple Capital Structure 889 Complex Capital Structure 890 Analytical Insights 893 Is Earnings per Share a Meaningful Number? 894 Accounting for Stock-Based Compensation 895 Historical Perspective 896 Opposition to the FASB 897 The Compromise SVAS No Stock Options Debate Rekindled 903 Current GAAP Requirements 905 Options Backdating Scandal 907 Convertible Debt 908 Background 909 Financial Reporting Issues 910 Analytical Insights 912 APPENDIX: Employee Stock Ownership Plans 914

7 XXII Contents Chapter 16 Intercorporate Equity Investments 939 Noncontrolling (Minority) Ownership 939 Minority Passive Investments: Accounting 940 Mark-to-Market Minority Active Investments: Equity Method 945 Fair Value Option for Equity Method Investments 949 Controlling Financial Interest (Majority Ownership) 950 Purchase Method and Preparation of Consolidated Statements 951 Adjustments to the Consolidated Balance Sheet 952 Other Consolidation Transactions 955 Adjustments Intercompany Noncontrolling (Minority) Interest under the Purchase Method 956 Acquisition Method 958 Accounting for Goodwill 961 Purchase Method versus Pooling-of-Interests Method 963 ' Purchase and Acquisition Methods Complicate Financial Analysis 965 Consolidation of Variable Interest Entities 967 Accounting for Foreign Subsidiaries 968 Foreign Currency Transactions 969 Accounting for Nonfreestanding Foreign Subsidiaries 971 Accounting for Self-Contained Foreign Subsidiaries 972 APPENDIX A: Accounting for Held-to-Maturity Debt Investments 977 APPENDIX B: Pooling-of-Interests Accounting 978 Purchase, Pooling, and Financial Analysis 979 Chapter 17 Statement of Cash Flows 1007 Statement Format 1008 The Direct Approach 1008 The Indirect Approach 1011 Other Elements of the Cash Flow Statement 1016 Preparing the Cash Flow Statement 1016 Cash Flows from Operations 1017 Cash Flows from Investing Activities 1022 Cash Flows from Financing Activities 1023 Reconciling between Statements: Some Complexities 1023 Discrepancies in Current Accruals 1025 Discrepancies Related to Property, Plant and Equipment 1027 Simultaneous Noncash Financing and Investing Activities 1028 Analytical Insights: Ways Operating Cash Flows Can Be Distorted or Manipulated 1030 Changes in Working Capital Accounts 1030 Accounts Receivable Sale (Securitization) versus Collateralized Borrowing 1030 Capitalizing versus Expensing 1031 Software Development Costs 1032 Capital versus Operating Leases 1033 Cash Flow Impact of Stock Option Expensing 1034 Chapter 18 Overview of International Financial Reporting Differences and Inflation 1069 International Financial Reporting 1070 Earlier Impediments to Foreign Securities Transactions 1070 Increased Predominance of the Economic Performance Approach 1071 International Accounting Standards Board 1074 Some Differences between U.S. GAAP and IFRS 1076 Coping with Reporting Differences That - Persist 1077 Inflation Accounting 1081 Current Cost Accounting 1082 General Price-Level Accounting 1089 Appendix I PresentValueTables 1109 Appendix II WWW/Electronic Resources for Index 1115 Financial Information 1112

ntermediate Accounting

ntermediate Accounting FIFTH EDITION J. DAVID SPICELAND University of Memphis JAMES F. SEPE Santa Clara University MARK W. NELSON Cornell University LAWRENCE A. TOMASSINI The Ohio State University McGraw-Hill