December 1, 2006
1. Define and explain the components of and relationship among the income statement, balance sheet, and cash flow statement.
2. Discuss ways that management can manipulate earnings by using discretion in presenting financial statements.
a. Income Smoothing: The technique of reducing earnings in good years, bydeferring gains and recognizing losses. Earnings can also be inflated in bad years, by recognizing gains and deferring losses.
b. Big Bath manipulation technique: The piling up of losses in recognized bad years in hopes of magnifying gains in the following good years.
c. Classification of good and bad news: Bias of reporting good news about the line (part of continuingoperations) and bad news below the line (extraordinary or discontinued operations).
d. Since there are no cash flow consequences to accounting changes (e.g., changes in depreciation methods, useful lives), they must be analyzed for earnings manipulation.
3. Identify the requirements for revenue recognition to occur.
1. Earnings activities are substantially completed.
2.Revenue can be measured with reasonable accuracy.
3. The major portion of the costs has been incurred, and the remaining costs can be reasonably estimated.
4. The eventual collection of the cash is reasonably assured.
5. Also remember that transactions giving rise to revenue should be arms-length.
4. How does a stock split affect the balance sheet?
It does not changethe amount in any asset, liability or SHE account. It does increase the number of shares of common stock issued and outstanding while proportionately decreasing the par or stated value of that common stock.
5. There are 2 identical firms. Firm A borrowed money to build a new factory, while Firm B issued equity to build an identical factory. How will these 2 firms’ cash flow statementsdiffer?
Firm A will have a lower Cash Flows from Operations than Firm B. Why? Firm A must pay interest on the debt, which comes out of CFO. Firm B has no required payments, but if Firm B paid out dividends this would decrease Cash Flows from Financing.
6. Distinguish between permanent and temporary tax differences. Which gives rise to a deferred tax asset or liability?Permanent differences are differences in taxable and pretax incomes that are never reversed.
Some examples are tax-exempt interest revenue and the proceeds from life insurance on key employees, both of which are not taxable but are recognized as revenue on the financial statements.
Tax-exempt interest expense and premiums paid on life insurance of key employees are examplesof expenses on the financial statements, but they are not deductions on the tax returns.
These differences are NEVER DEFERRED but are considered decreases or increases in the effective tax rate. If the only difference between taxable and pretax incomes were a permanent difference, then tax expense would be simply taxes payable.
Temporary differences are differences intaxable and pretax incomes that will reverse in future years. That is, current lower (higher) taxes payable will be a future higher (lower) taxes payable. These differences result in deferred tax assets or liabilities. Various examples are as follows:
LT liabilities: The LT tax liability that results by using a declining balance depreciation for the tax returns and SL depreciation forthe financial statements.
Current liabilities: The deferred tax assets created when warranty expenses are accrued on the financial statements but are not deductible on the tax returns until the warranty claims are paid.
LT assets: The deferred tax asset created when post retirement benefits expense in pretax income exceeds that allowed for a deduction on tax returns....