cases chap010

Chapter 10 - Other Items That Affect Net Income and Owner’s Equity

CHAPTER 10OTHER ITEMS THAT AFFECT

NET INCOME AND OWNER’S EQUITY

Changes from Twelfth Edition

Updated from Twelfth Edition. A new case – Proxim Inc. – has been added. The Kansas City Zephers case has been dropped.

Approach

This chapter contains several topics that instructors may wish to emphasize in varying degrees. In particular, the rather detailed rules on extraordinary items, discontinued operations, change in accounting principles, and correction of errors may be more than students can readily assimilate; they can always refer back to the rules if this becomes necessary.

Similarly, some instructors prefer not to get into foreign currency matters at all in an introductory course; some cover transactions but not translation; and others cover both, perhaps because of the increased emphasis on covering international issues in the overall core curriculum.

With respect to personnel costs, the important point is the difference between transactions that are costs to the company and those that result from the company serving as a collection agency for the government. In my own view, any details of pension accounting can be withheld for an intermediate course, but I want students to have an overview of the issues and complications of pension accounting.

I spend the most time on deferred taxes, both because virtually every set of financial statements students are likely to see will contain this item and because it always seems to be a difficult topic for students to master. The ease of teaching this subject diminished even further when MACRS allowances replaced the usual tax deprecation illustrations using sum-of-the-years’-digits depreciation. FAS109, in my view, further complicates matters.

Cases

Norman Corporation (B) raises some new, and reviews some old, issues in expense recognition.

Silver Appliance Company enables students to explore deferred tax accounting in the context of the installment method of reporting installment sales revenues.

Freedom Technology Company deals with the translation of financial statements. If desired, both the currently required method and alternative approaches can be compared.

Proxim, Inc. raises issues related to proforma earnings disclosures.

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Problems

Problem 10-1

Wages Payable 1,025.00Cash 776.35FICA Taxes Payable 74.65Withholding Taxes Payable 174.00And, to finish, payment to government:FICA Taxes Payable 149.30Unemployment Taxes Payable 40.05Withholding Taxes Payable 174.00Cash 363.35

Problem 10-2

dr. Pension Cost.......................................................................................................................................................................................85,000cr. Cash.................................................................................................................................................................................................40,100

Pension Liability.............................................................................................................................................................................44,900

Problem 10-3

Financial Statements (Accrual Basis)

2007 2008 2009 2010Revenues.................................................................................................................................................................................................$456,000 $696,000 $840,000 $780,000Expenses.................................................................................................................................................................................................. 270,000 672,000 798,000 618,000Profit before taxes................................................................................................................................................................................... 186,000 24,000 42,000 162,000Tax provision (30%)................................................................................................................................................................................ 55,800 7,200 12,600 48,600

Tax Return (Cash Basis)

2007 2008 2009 2010Receipts...................................................................................................................................................................................................$336,000 $636,000 $894,000 $690,000Disbursements......................................................................................................................................................................................... 288,000 528,000 750,000 606,000Taxable income....................................................................................................................................................................................... 48,000 108,000 144,000 84,000Tax payment (30%)................................................................................................................................................................................. 14,400 32,400 43,200 25,200

2007 2008 2009 2010Tax provision...........................................................................................................................................................................................$55,800 $ 7,200 $ 12,600 $48,600Tax payment............................................................................................................................................................................................ 14,400 32,400 43,200 25,200Difference................................................................................................................................................................................................ 41,400 (25,200) (30,600) 23,400Cumulative difference.............................................................................................................................................................................$41,400 $16,200 $(14,400) $ 9,000

Cash basis accounting for tax payment purposes was preferable for the 2007 - 10 period. It resulted in lower cumulative tax payments.

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The difference between the annual tax provision and tax payments would be handled through deferred tax accounting.

Problem 10-4

Net book value of machinery for financial reporting purposes

Year CostDepreciation

Expense

Cumulative Depreciation

Allowance Net Book Value2010 $2,750,000 $275,000 $ 275,000 $2,475,0002011 2,750,000 550,000 825,000 1,925,0002012 2,750,000 550,000 1,375,000 1,375,0002013 2,750,000 550,000 1,925,000 825,0002014 2,750,000 550,000 2,475,000 275,0002015 2,750,000 275,000 2,750,000 -0-

Net tax basis of machinery for tax purpose.

Year Tax BasisDepreciation

Deduction

Cumulative Depreciation

Deduction Net Tax Basis2010 $2,750,000 $550,000 $ 550,000 $2,200,0002011 2,750,000 880,000 1,430,000 1,320,0002012 2,750,000 528,000 1,958,000 792,0002013 2,750,000 316,250 2,274,250 475,7502014 2,750,000 316,250 2,590,500 159,5002015 2,750,000 159,500 2,750,000 -0-

Deferred Tax Liability Calculation

Year Net Book Value Net Tax Basis DifferenceDeferred Tax

Liability2010 $2,475,000 $2,200,000 $275,000 $110,0002011 1,925,000 1,320,000 605,000 242,0002012 1,375,000 792,000 583,000 233,2002013 825,000 475,750 349,250 139,7002014 275,000 159,500 115,500 46,2002015 -0- -0- -0- -0-

Income Tax Payments

YearProfit Before Depreciation Depreciation Taxable Income Tax Payment

2010 $1,500,000 $550,000 $ 950,000 $380,0002011 1,500,000 880,000 620,000 248,0002012 1,500,000 528,000 972,000 388,8002013 1,500,000 316,250 1,183,750 473,5002014 1,500,000 316,250 1,183,750 473,5002015 1,500,000 159,500 1,340,500 536,200

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Income Tax Provisions

YearProfit before Depreciation Depreciation Pretax Income Tax Provision

2010 $1,500,000 $275,000 $1,225,000 $490,0002011 1,500,000 550,000 950,000 380,0002012 1,500,000 550,000 950,000 380,0002013 1,500,000 550,000 950,000 380,0002014 1,500,000 550,000 950,000 380,0002015 1,500,000 275,000 1,225,000 490,000

Tax Provision Presentation

CurrentTax Expense

DeferredTax Expense

Total TaxProvision

2010 $380,000 $110,000 $490,0002011 248,000 132,000 380,0002012 388,800 (8,800) 380,0002013 473,500 (93,500) 380,0002014 473,500 (93,500) 380,0002015 536,200 (46,200) 490,000

In 2012 the deferred tax liability account reverses.

A T-account tracking of the 2010 - 2015 tax payments, tax provision and deferred tax liability balances can be constructed from the above schedules. Tax payments reduce cash. The deferred tax portion of the total tax provision is initially a credit to the deferred tax liability account (2010 - 11) and thereafter a debit entry.

Problem 10-5

1. APB Opinion No. 30 requires that in order to qualify as an extraordinary item, an event must satisfy two criteria:

1. The event must be unusual; it should be highly abnormal and unrelated to, or only incidentally related to, the ordinary activities of the entity.

2. The event must occur infrequently; it should be of a type that would not reasonably be expected to recur in the foreseeable future.

Item “5” (loss of $300,000 due to explosion caused by disgruntled ex-husband of an employee) meets the two extraordinary-item criteria.

Item “1” is explicitly excluded by APB No. 30 as an extraordinary item.

Item “2” is not an extraordinary item. Hurricanes are not an infrequent event in Louisiana.

Item “3” may be considered an extraordinary item if floods in northern New Mexico occur infrequently.

Item “4” is not an extraordinary item. Selling segments of a business is a frequent business activity.

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2. Income before extraordinary item...................................................................................................................................................................................$XXX,XXXExtraordinary item, net of applicable income taxes ($90,000)........................................................................................................................................................................................ 210,000

Net income $XXX,XXX

Problem 10-6

a. and b. 1. dr. Inventory............................................................................................................................................................................................57,600cr. Note Payable....................................................................................................................................................................................57,600

2. dr. Note Receivable.................................................................................................................................................................................2,700cr. Sales.................................................................................................................................................................................................2,700

3. dr. Accounts Receivable..........................................................................................................................................................................720,000cr. Sales.................................................................................................................................................................................................720,000

4. dr. Inventory............................................................................................................................................................................................119,600cr. Account Payable..............................................................................................................................................................................119,600

c. 1. Note Payable (year end)..........................................................................................................................................................................$ 60,000Note Payable (transaction date)............................................................................................................................................................... 57,600

Exchange loss......................................................................................................................................................................................$ 2,400

2. Note receivable (year end)......................................................................................................................................................................$ 3,000Note receivable (transaction date)........................................................................................................................................................... 2,700

Exchange gain.....................................................................................................................................................................................$ 300

3. Account receivable (year end).................................................................................................................................................................$692,308Account receivable (transaction date)..................................................................................................................................................... 720,000

Exchange loss......................................................................................................................................................................................$ 27,692

4. No exchange gain or loss. Exchange rate unchanged.

Cases

Case 10-2: Silver Appliance Company *

Note: This case has been updated from the Twelfth Edition.

Approach

This case enables students to get some “hands-on” experience in dealing with the complex matter of deferred taxes, and also in applying the installment method that was described in Chapter 5. It also requires them to think through how these complexities can be explained to a nonaccountant, and to recognize that a change in accounting method for tax purposes may involve transitional problems relating to potential double taxation of income.

*This teaching note was prepared by James S. Reece. Copyright © James S. Reece.

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Many students will have difficulties figuring out the calculations required for Question 1. These difficulties can be mitigated by including on the assignment sheet a worksheet format like that used in Exhibit A of this note. Alternatively, we can hand out in class a copy of Exhibit A, or have them copy it from a transparency. In any event, in class I go through an example for one year using T accounts, as follows:

“Book” TaxSales.........................................................................................................................................................................................................$1,000 $900Cost of sales @ 70%............................................................................................................................................................................... 700 630Gross margin........................................................................................................................................................................................... 300 270Other expenses........................................................................................................................................................................................ 200 200Pretax income.......................................................................................................................................................................................... 100 70Income tax expense @ 34%.................................................................................................................................................................... 34 23.8Actual taxes as percent of pretax “Book” income...................................................................................................................................34% 23.8%

Cash (or TaxesPayable)

Income TaxExpense

DeferredTaxes

23.8 34 10.2

This illustrates both the basic concept of deferred taxes, and also the rationaletaxes as a percent of pretax income would be understated (23.8% instead of the “true” 34%) if the “book” income tax expense amount were the amount of actual taxes rather than the actual tax rate applied to “book” pretax income. This example uses the deferral method--rather than the liability method--to compute deferred taxes. Students find this deferral method easier to understand.

Comments on Questions

Question 1

The required calculations are displayed in Exhibit A. Line 8 shows how much less Silver’s taxes would have been in 2005-10 and that taxes would have been higher in 2010 using the installment method. Line 9 shows each year’s year-end balance of Deferred Taxes; again, note that the reversal in 2010 causes the balance to decrease.

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Exhibit ASILVER APPLIANCE COMPANY

(In Thousands)

2006 2007 2008 2009 2010(1) Year-end installment receivables............................................................................................................................................................$190.1 $351.9 $526.2 $559.4 $489.1(2) Gross margin %....................................................................................................................................................................................... 34.6% 35.1% 34.2% 33.4% 32.2%(3) Deferred gross margin (= 1 * 2).............................................................................................................................................................. 65.77 123.52 179.96 186.84 157.49(4) Pretax profit, delivery basis..................................................................................................................................................................... 332.6 415.3 478.2 492.5 461.3(5) Income taxes, delivery basis (34% of 4)................................................................................................................................................. 113.08 141.20 162.59 167.45 156.84(6) Pretax profit, installment basis (= 4 - 3 +

previous year’s 3) 47.31.......................................................................................................................................................................... 266.83 357.55 421.76 485.62 490.65(7) Income taxes, installment basis (34% of 6)............................................................................................................................................. 90.72 121.57 143.40 165.11 166.82(8) Tax deferred (5 - 7)................................................................................................................................................................................. 22.361 19.632 19.19 2.34 (9.98)(9) Cumulative tax deferred.......................................................................................................................................................................... 22.36 41.99 61.18 63.52 53.54

1Liability method calculations is Line 3 ($65.77) times 34 percent.2Liability method calculations is $41.99 minus $22.36 (see line 9).

Question 2

The balance in the deferred tax account is best described as the cumulative amount of taxes that the company has postponed by using the installment method rather than the delivery method for tax purposes. Some people refer to this as “an interest-free loan from the government.” This is true in the sense that these funds would have been paid in taxes if the tax laws did not permit use of the installment method. In another sense, it is not true: if the company used the installment method for both “book” and tax purposes, the company would have the same cash-flow benefit, but would not show any deferred tax accounting (ignoring other possible book-tax accounting differences); that is, it would have the same “loan,” even though the “loan” would not be reflected in the balance sheet.

I also feel it should be explained to Mr. Silver that deferred taxes are a liability, but not in the same sense that taxes payable are. Personally, I find the APB’s analogy in Opinion No. 11 very compelling: like accounts payable, deferred taxes do come due and get paid, even though the balance in the account may grow because each year’s credits (new payables or deferrals) exceed that year’s debits (accounts paid or deferral reversals). Indeed 2010’s simultaneous drop in installment sales and gross margin percentage relative to 2009 clearly illustrates the phenomenon of turnover within the Deferred Taxes account. Like Mr. Silver’s architect friend, Silver’s taxes could remain essentially constant even though delivery-basis sales and profit have declined (see lines 4 and 6 of Exhibit A).

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The instructor may wish to indicate in advance that he or she does not expect students to check the tax code regarding the double taxation issue. The point of the question is to make students realize that there can be transitional problems surrounding a change in accounting method for tax purposes. Students should at least be able to answer, “There will be double taxation on installment sales recognized in 2010 under the delivery method, but not collected until 2011 when the installment method is adopted, unless the tax laws recognize this problem and provide relief for it.” In fact, the tax law (Sec. 453) says that Silver would have to report in 2011 all installment collections made in 2011, but could adjust 2011 taxes downward for those 2011 collections that were taxed under the delivery method in 2010. In effect, then, Silver would get a refund of that portion of 2010 taxes that related to installment sales that were reported in both 2010 and 2011, and would be taxed on these collections only in 2011.

Although the question is not explicitly asked, the discussion should end with resolution of the issue as to whether Silver should change to the installment method. If students have previously raised a similar question on a switch from FIFO to LIFO, having seen here that 2010 taxes would have been higher on the installment basis than the delivery basis, they are tempted to answer, “It depends on the expected future relationship between income on the installment basis and the delivery basis.” However, in this instance that answer is not correct. Unless tax rates are expected to be increased, the installment method will always provide some advantage: there is no way (given no double taxation in the year of change) that a change from the delivery basis to the installment basis could result at any time in a negative (debit) balance in Deferred Taxes. Thus, the change should be made.

Case 10-3: Freedom Technology Company *

Note: This case is unchanged from the Twelfth Edition.

Approach

Because FASB 8 proscribed the earlier freedom of choice of a translation method, and then FASB 52 changed FASB 8’s method, I prefer teaching this case with a “legislative history” flavor, rather than just dealing with the mechanics of the net investment or current rate method. While the students still learn the basics behind the net investment method, they gain a better understanding of the translation concept in general and also are exposed to the lengthy controversy surrounding some otherwise apparently innocuous accounting rules. Of course, some instructors will choose to assign only Question 1.

This topic is not included in many “core” financial accounting courses. However, with the increase in multinational operations of businesses, and the resultant concern about international content in the business core curriculum, the topic seems more germane to the core course than it did in previous years.

Comments on Questions

I begin class with a student presenting the statements called for in questions 1 and 2 (see Ex. A and B). Using the text example (Illustration 10-7) as a basis, students have little trouble with the net investment method, except for the equity items. Some will forget to translate capital stock at the rate in effect when it was issued. While most will have gotten the translation adjustment as a “plug” figure, many will have trouble directly calculating it. As indicated at the bottom of Exhibit A, the importance of the calculation is not the mechanics so much as the insight one gains into what the adjustment represents.

*This teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

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The remeasurement of monetary/nonmonetary method is more difficult, both because it is not illustrated in the text and because of the nonmonetary asset adjustments’ being different from those in the net investment method. These difficulties should not be permitted to obscure the different investment exposure concepts behind the two methods. The net investment method views the owners’ equity as being exposed to exchange rate fluctuations; i.e., fluctuations in assets’ translated amounts are offset to the extent possible by liability fluctuations, leaving exposed only the portion of assets financed by equity. By contrast, the monetary/nonmonetary method treats nonmonetary assets as a hedge against unfavorable exchange rate fluctuations. (Compare especially the translated amounts for fixed assets under the two methods.)

One word of caution is in order. To keep this problem as simple as possible, the foreign entity was formed at the start of the current year (i.e., October 1, 20xl). It is for this reason (plus the assumption of no dividends) that in Exhibits A and B the year-end retained earnings are the same as the year’s net income. In succeeding years, the concept for getting the translation gain or loss as a “plug” figure remains the same, but the mechanics become slightly more complex. (In fact, in practice this item is derived as a plug figure, rather than calculated directly.)

This case example clearly illustrates the reason the translation method controversy at least among statement preparersseems to have died down since the issuance of FASB 52. In circumstances such as those faced by Freedom A (i.e., foreign currency value dropping relative to the dollar), the monetary/nonmonetary method reports a smaller translation loss; hence, in pre-FASB 8 days, this method would have been the better of the two from management’s standpoint. The preparers’ real objection to FASB 8, in my view, was not the method so much as it was treating the translation gain or loss as an element of net income. Despite a company’s best efforts to keep operating earnings consistently on the rise, the translation gain or loss caused fluctuations, resulting in great consternation among top managers.

This phenomenon can lead the class, if the instructor wishes, into a discussion of the efficient markets hypothesis as it relates to accounting methods. According to EMH, the translation method used should have no impact on stock price, since cash flow is independent of method used. Of course, if management, given a method they must use (e.g., monetary/nonmonetary), changes its decisions solely to influence the result reported by the accounting method, then stock price could be affected because cash flows could be different. A study done by Professor Shank, et al. (see Financial Executive, Feb. 1980 for a summary) revealed that companies were in fact engaging in transactions that were induced more by FASB 8 than by purely economic considerations, especially currency hedging transactions. The study also indicated that FASB 8 did not change the market’s perception of the riskiness of firms affected by FASB 8, and the managements’ FASB 8 induced action was therefore unwarranted. To quote the study, “Managers are so committed to the importance of the accounting numbers that they will undertake actions in the foreign currency area which they know will increase expected costs and risk levels just to preserve desired relationships in the accounting numbers.”

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Exhibit ANet Investment Translation Method

(won in millions, dollars in thousands)Freedom-Korea

Balance Sheet as of September 30, 20x2

Assets Won Exchange Rate DollarsCash......................................................................................................................................................................................................... W591 $0.00124 $ 732.8Receivables.............................................................................................................................................................................................. 1,182 0.00124 1,465.7Inventories............................................................................................................................................................................................... 552 0.00124 684.5Fixed assets ............................................................................................................................................................................................. 575 0.00124 713.0

W2,900 $3,596.0Liabilities and Owners’ EquityCurrent liabilities..................................................................................................................................................................................... W624 0.00124 $ 773.8Capital stock............................................................................................................................................................................................ 1,000 0.00140 1,400.0Retained earnings.................................................................................................................................................................................... 1,276 (see below) 1684.3Accum. translation adjustments.............................................................................................................................................................. ---- * (262.1)

W2,900 $3,596.0

Income Statement for the year ended September 30, 20x2

Revenues................................................................................................................................................................................................. W7,090 $0.00132 $9,358.8Cost of sales ............................................................................................................................................................................................ 4,415 0.00132 5,827.8Other expenses........................................................................................................................................................................................ 1,399 0.00132 1,846.7Net Income.............................................................................................................................................................................................. W1,276 $1,684.3

* Calculation of translation loss:Oct. 1, 20xl net assets = W1,000

Translated at Sept 30, 20x2 rate = 1,000 * $0.00124...........................................................................................................................$ 1,240.0Translated at Oct. 1, 20xl rate = 1,000 * 0.00140................................................................................................................................1,400.0Loss on beginning-of-year net assets...................................................................................................................................................$ (160x.0)

Increment in net assets during FT 20x2 = W 1,276Translated at Sept 30,20x2 rate = 1,276 * $0.00124............................................................................................................................$1,582.2Translated at average FY 20x2 rate = 1,276 * 0.00132....................................................................................................................... 1,684.3Loss on increment in net assets............................................................................................................................................................$ (102.1)

Total loss in dollar value of net assets.....................................................................................................................................................$ (262.1)

(The loss figure can be determined without the above calculation, since the loss is the amount needed to make the balance sheet balance; but the calculation shows the rationale behind the loss, i.e., the loss occurred because the parent held South Korean won net assets while the value of the won fell relative to the dollar.)

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Exhibit BMonetary/Nonmonetary Translation Method

(won in millions, dollars in thousands)Freedom-Korea

Balance Sheet as of September 30, 20x2

Assets Won Exchange Rate DollarsCash......................................................................................................................................................................................................... W591 $0.00124 $ 732.8Receivables.............................................................................................................................................................................................. 1,182 0.00124 1,465.7Inventories............................................................................................................................................................................................... 552 0.00126 695.5Fixed assets.............................................................................................................................................................................................. 575 0.00140 805.0

W2,900 $3,699.0Liabilities and Owners’ EquityCurrent liabilities..................................................................................................................................................................................... W624 0.00124 $ 773.8Capital stock............................................................................................................................................................................................ 1,000 0.00140 1,400.0Retained earnings.................................................................................................................................................................................... 1,276 (“plug”) 1,525.2

W2,900 $3,699.0

Income Statement for the year ended September 30, 20x2

Revenue...................................................................................................................................................................................................W7,090 $0.00132 $9,358.8Cost of sales............................................................................................................................................................................................. 4,415 0.00132* 5,827.8*Other expenses (excl. deprec.)................................................................................................................................................................ 1,374 0.00132 1,813.7Depreciation............................................................................................................................................................................................ 25 0.00140 35.0Operating income.................................................................................................................................................................................... 1,276 1,682.3Translation gain (loss)............................................................................................................................................................................. ---- (“plug”) (157.1)Net Income .............................................................................................................................................................................................W1,276 $1,525.2

*This is an approximation. A precise calculation incorporates beginning and ending inventories, as well as purchases, thus:

Beginning inventory................................................................................................................................................................................ W0 0.00140 $ 0.0Plus purchases......................................................................................................................................................................................... 4,967 0.00132 6,556.4Less ending inventory............................................................................................................................................................................. (552) 0.00126 (695.5)Cost of sales.............................................................................................................................................................................................W4,415 $5,860.9

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Case 10-4: Proxim Inc. * Note: This case is unchanged from the Twelfth Edition..

ApproachAccounting earnings have long been the key summary measure of corporate performance. Investors have focused on earnings computed in accordance with generally accepted accounting principles—GAAP-for many years. However, recent years have brought a dramatic increase in the use of alternative definitions of earnings, known by such names as pro forma, core or cash earnings. Although such earnings definitions are part of management voluntary disclosure and not under the purview of the FASB, these

*This teaching note in an excerpt from a longer note, Management Earnings Discloses and Pro Forma Reporting prepared by Professor Mark T. Bradshaw.

Copyright © 2003 President and Fellow of Harvard College. Harvard Business School teaching note 103-082.

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new definitions of earnings frequently appear in corporate news releases and are disseminated widely in the financial press.

The purpose of Proxim, Inc. is to expose students to the quarterly earnings disclosures that play such an important role in the managerial reporting environment among publicly traded firms and to use the pro forma disclosure phenomenon to get students thinking about the trade-offs between strict regulation of management communication versus a more hands-off approach.

Teaching Objectives

This case works best when introduced after students have learned basic financial accounting concepts and specific accounting rules, particularly rules pertaining to revenue and expense recognition. The structure of the case is to begin with a broad but brief discussion of the importance of the quarterly earnings announcement season, followed by an introduction to alternative definitions of earnings used in management press releases, and closing with a discussion of regulatory and market responses to these disclosures at both the national and international level. For specific case discussions, the financial statement and press release information are included for Proxim, Inc., a company that excludes a variety of different expenses and gains from its reported earnings. At the end of the case discussion, students should:

Be aware of the importance of reported earnings for public companies

Understand that Pro Forma Earnings = GAAP Earnings + SOME EXPENSES

View the pro forma debate is symbolic of the difficulty in establishing accounting rules

Appreciate the trade-off inherent in regulation vs. non-regulation

Structure of Class Discussion

The order in which material is discussed in this case does not seem particularly crucial to the success of the case. Class discussion can occur in any order, ranging from specific discussion of Proxim and then moving to a more general discussion of the pro forma phenomenon and regulatory issues. Alternatively, the class can begin at the broad level, discussing the general issues and then moving into a specific discussion of Proxim. The teaching note is structured along the latter method, although the experience of different instructors varies widely.

Summary questions that might be addressed are as follows:

1. How and why do managers communicate their financial performance?

2. What are pro forma earnings?

3. Are pro forma earnings good or bad?

4. What do you think of the Proxim earnings announcement?

5. Should pro forma earnings be regulated?

What follows is a list of questions that support these six primary questions, along with brief comments that instructors should elicit from members of the class.

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Discussion questions

1. How and why do managers communicate their financial performance?

a. Why are there earnings announcements?i. These are exchange rules, not rules imposed by the SEC or FASB.

ii. Earnings summarize financial performance, which is important to investors interested in the earnings power of a company and its ability to pay interest and dividends.

iii. Earnings realizations help predict future earnings.

iv. Earnings are a better proxy for future cash flows than current cash flows (e.g., see Accounting Earnings and Cash flows as Measures of Firm Performance: The Role of Accounting Accruals” by Patricia M. Dechow, Journal of Accounting and Economics, 1994, pp. 3-42).

b. How frequently are accounting earnings reported?

i. Quarterly.

ii. Since most firms have December fiscal year ends, peak periods are April, July, October, and January/February.

c. Why not report earnings more frequently, say monthly?

i. The SEC requires quarterly statements filed on form 10-Q, making it natural to announce summary information from them to the market via press releases.

ii. Quarterly reporting is an attempt to provide a balance between timeliness and the cost of more frequent reporting.

iii. That being said, some firms do report more frequently, such as retailers who often announce monthly results.

d. How else do managers communicate with investors?

i. Informational press releases.

1) e.g., new products, regulatory approvals, etc.

ii. Earnings preannouncements.

1) These are particularly more common in the case of ‘bad news.’

2) There is an implicit belief that announcing bad news earlier results in less negative impact than waiting to announce it later.

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3) Preannouncements are presumably a memo for managers to signal that they are forthcoming and credible communicators of financial performance.

iii. Conference calls.

1) Press releases often announce the date and time of upcoming conference calls.

2) Conference calls provide an opportunity for analysts, the press, and investors to ask more probing questions regarding results of operations.

3) Conference calls are believed to be part of the new compliance with Regulation FD.

iv. Mailings to investors.

1) Form 10-Qs.

2) Form 10-Ks and annual reports.

v. Interviews on business programs

1) e.g., CNBC Squawk Box, etc.

2. What are pro forma earnings?

a. For the longest time, it meant ‘what earnings would have been if two merging companies had been merged in prior periods’ or ‘what earnings would have looked like if some division/company that was recently sold/disposed had been gone in prior periods.’

b. Generally, any ‘what if’ scenario qualifies as ‘pro forma’ earnings.

c. Pro forma disclosures are often referred to as “non-GAAP” disclosures.

d. Actually, it is more descriptive to call them “incomplete-GAAP” disclosures.

e. Simply a different calculation of Revenues - Expenses +/- Gains/Losses, some items excluded from the equation

f. More often than not, the items excluded from the calculation are expenses and losses rather than revenues or gains.

g. Items excluded in pro forma earnings include just about every operating expense on the income statement.

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i. Restructuring charges.

ii. Asset write-offs.

iii. Depreciation and amortization.

iv. Merger-related charges.

v. Compensation-related expenses.

vi. R&D.

vii. Acquired in-process R&D.

viii.Bad debt expense.

ix. Litigation costs.

x. Interest expense.

3. Are pro forma earnings ‘good’ or ‘bad’?

a. Good.

i. One-time items are important to know about, but obscure earnings as a summary measure of recurring or core earnings, so it is appropriate and even desirable to exclude the effects of these transitory items from reported earnings.

ii. Graham and Dodd (the financial analyst ‘bible’) focuses extensively on the analysis of financial data to identify ‘earnings power,’ which is the level of recurring earnings. Accordingly, they devote extensive discussion to the assessment of non-recurring items that should be excluded from earnings when attempting to forecast future earnings.

iii. Much financial analysis is time-series in nature, and a comparable set of time-series numbers is more useful to investors.

iv. It can be argued that investors cannot be worse off by knowing pro forma earnings so long as they also know either GAAP earnings (i.e., net income) and/or the amounts of items excluded from GAAP earnings to arrive at pro forma earnings. As a simple example, let Revenue = R, Expensel = E1, Expense2 = E2, NI = Net income = R-El-E2, and PF = Pro Forma income = R-E1 or = NI+E2.

1) If an investor knows NI, then they are aware of the single GAAP summary figure only.

2) If an investor knows both NI and PF, then they also know that E2 = PF-NI.

3) If an investor knows both PF and E2; then they also know NI = PF-E2, or E2 = PF-NI as above.

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4) Therefore, it seems like announcing pro forma earnings can actually give investors more information.

v. Highlighting abnormal, non-recurring, or non-cash income statement items has been done by managers for years. Thus, is ‘pro forma’ just a case of ‘old wine in new bottles’?

b. Bad

i. It appears that most financial statement line items excluded are expenses/losses, rather than revenues/gains. This asymmetric occurrence of excluded items makes it suspicious that managers are simply reporting results in an unbiased manner.

1) However, students should be reminded that GAAP is conservative by nature, resulting more frequently in the earlier recording of expenses/losses than revenues/gains.

ii. Pro forma reporting seems like another way of manipulating investors. Manipulating pro forma earnings, which are not filed with the SEC, is perhaps easier to do than manipulating GAAP financial numbers themselves, which are filed with the SEC and hence, subject to more scrutiny and potential penalties.

iii. Managers seem to be emphasizing pro forma numbers, not the GAAP numbers. The fact that pro forma numbers are almost always higher than GAAP numbers makes this seem a bit suspect.

iv. There are no ‘rules’ established, thus it is difficult to compare the pro forma earnings of one company to those of another company, or perhaps even the pro forma earnings for the same company in different quarters/years.

v. Howard Schilit (a former accounting professor who sells accounting analysis reports to Wall Street investors) says (paraphrased), “Letting managers come up with their own scorecards is like letting the inmates run the asylum.”

vi. If investors do not really pay attention to financial statement details when assessing stock values (i.e., they use a P/E multiplier to estimate fair values of share prices based on reported earnings per share), then they could be hurt by reliance on a pro forma earnings number that gives an incomplete picture of the full costs of operating the business. As an example of how reported earnings can affect aggregate assessments of economy-wide economic activity,

vii. If one does not consider the effects of ‘excluded’ charges in calculating pro forma earnings numbers in a particular period, then when should these costs be considered?

4. What do you think of the Proxim earnings announcement?

a. It is helpful to have presented the students with a poll before class, in which students are asked to quantify the earnings figure that they would have reported.

b. Proxim has excluded almost every expense in their pro forma earnings.

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c. $106 million of expenses are excluded on just $85 million of revenues.

i. Inventory write-down ($50 million).

ii. Restructuring charges ($14 million).

iii. Impairment loss on investments ($12 million).

iv. Goodwill impairment charge ($10 million).

v. Goodwill amortization ($5 million).

vi. Provision for doubtful accounts ($5 million).

vii. Terminated merger costs ($3 million).

viii. Patent litigation costs ($3 million).

ix. Amortization of intangibles ($3 million).

x. Purchased R&D ($1 million).

1) An interesting discussion is to address what ‘purchased’ or ‘acquired’ in process R&D is.

2) When a company buys another company, it must estimate the fair market value of all assets acquired (recall goodwill/intangibles discussions earlier in the term).

3) One intangible asset often acquired is the value of research and development (R&D) activities that are in process. Accounting rules require R&D activities to be expensed as incurred, but in a purchase situation firms are allowed to estimate the value of the ‘knowledge in process’ that is being acquired.

4) A common practice is to value such in process R&D, then ‘flash’ this value to Wall Street (i.e., ‘Hey, look at what we are buying . . . a bunch of promising research projects!’). Immediately thereafter, the manager of the acquiring company ‘flushes’ this amount (i.e., expenses it off the balance sheet). (See further discussion in the article “Flash-then-Flush: The Valuation of Acquired R&D-in-Process,” by Zhen Deng and Baruch Lev.) This practice is widely used, and the benefits to acquiring firms are threefold:

(1) Managers get to take credit for buying such promising assets (the ‘flash’).

(2) The market generally disregards the one-time write-off as nonrecurring (the ‘flush’).

(3) Future earnings will be unaffected by any amortization of the acquired goodwill asset, which would have occurred had the valued assets not been flushed.

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d. About the only expenses Proxim did not exclude were COGS, SG&A, and R&D. It makes one wonder why they did not go ahead and exclude R&D, arguing that such amounts should really be viewed as investments.

i. An interesting diversion is often demonstrating the perils of ignoring certain expenses.

ii. For example, assuming that acquired R&D is an asset, the related expenses are initially added back in computing ‘pro forma’ earnings.

iii. However, what future period should investors consider the related amounts to be recognizable expenses?

iv. Managers who exclude depreciation or amortization expense are making similar arguments for why the amounts are added back to arrive at pro forma earnings (but also invoking the ‘noncash’ argument).

v. Under the same logic as above for the R&D thought exercise, how come managers never report to investors what period is the appropriate one for actually deducting the initial expenditures on PP&E or intangible assets?

e. As an investor, are you more interested in the positive $0.06 pro forma earnings per share, or the $3.87 loss per share?

i. Perhaps both.

ii. The pro forma number gives an investor a figure that hopefully reflects what to expect on an ongoing basis in the future.

iii. The GAAP figure informs the investor on what has happened to previous investments made by management.

iv. Students should be reminded of earlier discussions in class related to the accounting for goodwill and other intangibles. One of the nice aspects of the purchase method is that it keeps a ‘reminder’ on the balance sheet of the amounts managers paid for other companies. No longer applicable, since FAS 142 disallows systematic write-off or goodwill

v. Regardless of whether one believes Proxim is trying to ‘fool’ investors, the company clearly has given investors a reasonable disclosure of what they excluded from pro forma earnings.

vi. However, keep in mind that the press has the option of picking up all the details in the press release, or simply picking up the pro forma number. Given space constraints, it is unlikely that all information in the press release will be reported in the business press.

vii. Nonetheless, some weeks after the earnings announcement, Proxim will file statements with the SEC. Thus, one worst-case scenario is that investors just receive the full set of information with a delay.

5. Should pro forma earnings be regulated?

a. Do regulate.

i. If pro forma earnings were to be regulated, this would essentially be equivalent to sanctioning another method of accounting (in addition to GAAP).

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ii. Further, regulating pro forma earnings would be tantamount to a tacit confession that GAAP is ‘broken’ and must be supplemented by another set of earnings figures.

iii. Economics across firms vary sufficiently that any dried rules would probably result in some firms being prevented from communicating their results effectively.

iv. If managers are using pro forma earnings strategically, they might revert to manipulation of the GAAP numbers rather than relying on the use of “pro forma’ earnings to ‘fool’ investors (e.g., this might lead to a decline in the quality of GAAP numbers).

b. Do not regulate.

i. Perhaps it is acceptable to allow continued confusion over what ‘pro forma’ means.

ii. Avoiding specific regulation of how ‘pro forma’ earnings should be computed allows managers freedom to communicate to investors in a manner that best fits their results and operations, which as noted above, vary widely across companies.

iii. It is possible that the SEC could use a ‘heavy hand’ to punish blatant abuses as a means of keeping a check and balance on managerial freedom to report such ‘incomplete-GAAP’ numbers.

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