Chapter 8 Segment and Interim Reporting

CHAPTER 8 SEGMENT AND INTERIM REPORTING Chapter Outline I. In the past, consolidation of financial information made the analysis of diversified companies quite difficult. A. The consolidation process tends to obscure the individual characteristics of the various component operations. B. Many groups called for the presentation of disaggregated financial data as a means of enhancing the information content of corporate financial reporting. II. The move toward dissemination of disaggregated information culminated in December 1976 with the release by the FASB of Statement 14, “Financial Reporting for Segments of a Business Enterprise.” A. This pronouncement required extensive disclosures pertaining to industry segments, domestic and foreign operations, export sales, and major customers. B. Although financial analysts found segment information to be very useful, they consistently requested that financial information be disaggregated to an even greater extent than was done in practice. C. Of particular concern was SFAS 14’s “dominant industry rule” which allowed many companies to avoid providing disaggregated data by industry segment. III. In response to the demand by financial analysts for improvements in segment reporting, the FASB issued Statement 131, “Disclosures about Segments of an Enterprise and Related Information” in June 1997. A. SFAS 131 adopts a management approach in which segments are based on the way that management disaggregates the enterprise for making operating decisions; these are referred to as operating segments. B. Operating segments are components of an enterprise which meet three criteria. 1. Engage in business activities and earn revenues and incur expenses. 2. Operating results are regularly reviewed by the chief operating decision-maker to assess performance and make resource allocation decisions. 3. Discrete financial information is available from the internal reporting system. C. Once operating segments have been identified, three quantitative threshold tests are then applied to identify segments of sufficient size to warrant separate disclosure. Any segment meeting even one of these tests is separately reportable. 1. Revenue test—segment revenues, both external and intersegment, are 10 percent or more of the combined revenue, external and intersegment, of all reported operating segments. 2. Profit or loss test—segment profit or loss is 10 percent or more of the greater (in absolute terms) of the combined reported profit of all profitable segments or the combined reported loss of all segments incurring a loss. 3. Asset test —segment assets are 10 percent or more of the combined assets of all operating segments. 8-1 D. SFAS 131 also sets several general restrictions on the presentation of operating segments. 1. Separately reported operating segments must generate at least 75 percent of total sales made by the company to outside parties. 2. Ten is suggested as the maximum number of operating segments that should be separately disclosed. If more than ten are reportable, the company should consider combining some operating segments. E. Information to be disclosed by operating segment. 1. General information about the operating segment including factors used to identify operating segments and the types of products and services from which each segment derives its revenues. 2. Segment profit or loss and the following components of profit or loss. a. Revenues from external customers. b. Revenues from transactions with other operating segments. c. Interest revenue and interest expense (reported separately). d. Depreciation, depletion, and amortization expense. e. Other significant noncash items included in segment profit or loss. f. Unusual items (discontinued operations and extraordinary items). g. Income tax expense or benefit. 3. Total segment assets and the following related items. a. Investment in equity method affiliates. b. Expenditures for additions to long-lived assets. IV. Enterprise-wide disclosures. A. Information about products and services. 1. Additional information must be provided if operating segments have not been determined based on differences in products and services, or if the enterprise has only one operating segment. 2. In those situations, revenues derived from transactions with external customers must be disclosed by product or service. B. Information about geographic areas. 1. Revenues from external customers and long-lived assets must be reported for (a) the domestic country, (b) all foreign countries in which the enterprise has assets or derives revenues, and (c ) each individual foreign country in which the enterprise has material revenues or material long-lived assets. 2. The FASB does not provide any specific guidance with regard to determining materiality of revenues or long-lived assets; this is left to management’s judgment. C. Information about major customers. 1. The volume of sales to a single customer must be disclosed if it constitutes 10 percent or more of total sales to unaffiliated customers. 2. The identity of the major customer need not be disclosed. V. To provide investors and creditors with more timely information than is provided by an annual report, the U.S. Securities and Exchange Commission (SEC) requires publicly traded companies to provide financial statements on an interim (quarterly) basis. A. Quarterly statements need not be audited. 8-2 Solutions Manual VI. APB Opinion No. 28 requires companies to treat interim periods as integral parts of an annual period rather than as discrete accounting periods in their own right. A. Generally, interim statements should be prepared following the same accounting principles and practices used in the annual statements. B. However, several items require special treatment for the interim statements to better reflect the expected annual amounts. 1. Revenues are recognized for interim periods in the same way as they are on an annual basis. 2. Interim statements should not reflect the effect of a LIFO liquidation if the units of beginning inventory sold are expected to be replaced by year-end; inventory should not be written down to a lower market value if the market value is expected to recover above the inventory's cost by year-end; and planned variances under a standard cost system should not be reflected in interim statements if they are expected to be absorbed by year-end. 3. Costs incurred in one interim period but associated with activities or benefits of multiple interim periods (such as advertising and executive bonuses) should be allocated across interim periods on a reasonable basis through accruals and deferrals. 4. The materiality of an extraordinary item should be assessed by comparing its amount against the expected income for the full year. 5. Income tax related to ordinary income should be computed at an estimated annual effective tax rate; income tax related to an extraordinary item should be calculated at the margin. VII. FASB Statement No. 154, “Accounting Changes and Error Corrections,” provides guidance for reporting changes in accounting principles including those made in interim periods. A. Unless impracticable to do so, an accounting change is applied retrospectively, that is, prior period financial statements are restated as if the new accounting principle had always been used. B. When an accounting change is made in other than the first interim period, information for the interim periods prior to the change should be reported by retrospectively applying the new accounting principle to these pre-change interim periods. C. If retrospective application of the new accounting principle to interim periods prior to the change of change is impracticable, the accounting change is not allowed to be made in an interim period but may be made only at the beginning of the next fiscal year. VIII. Many companies provide summary financial statements and notes in their interim reports. A. APB Opinion No. 28 imposes minimum disclosure requirements for interim reports. 1. Sales, income tax, extraordinary items, cumulative effect of accounting change, and net income. 2. Earnings per share. 3. Seasonal revenues and expenses. 4. Significant changes in estimates or provisions for income taxes. 5. Disposal of a business segment and unusual items. 8-3 6. Contingent items. 7. Changes in accounting principles or estimates. 8. Significant changes in financial position. 8-4 Solutions Manual B. Disclosure of balance sheet and cash flow information is encouraged but not required. If not included in the interim report, significant changes in the following must be disclosed: 1. Cash and cash equivalents. 2. Net working capital. 3. Long-term liabilities. 4. Stockholders' equity. IX. Four items of information must also be disclosed by operating segment in interim financial statements: revenues from external customers, intersegment revenues, segment profit or loss, and, if there has been a material change since the annual report, total assets. Learning Objectives Having completed Chapter 8 of this textbook, “Segment and Interim Reporting,” students should be able to fulfill each of the following learning objectives: 1. Identify the financial analysis problems associated with consolidated financial statements. 2. Discuss the method by which an enterprise determines its operating segments and the factors that influence this determination. 3. Identify and apply the three tests that are used to determine which operating segments are of significant size to warrant separate disclosure. 4. List the basic disclosure requirements for operating segments. 5. Describe the various limitations within which the number of separately disclosed operating segments should fall. 6. Explain when enterprise-wide disclosures related to products and services is required. 7. Explain when and what types of information about geographic areas must be disclosed. 8. Describe the criterion by which sales to a single unaffiliated customer are measured to determine whether disclosure is required. 9. Explain the "integral" approach followed in preparing interim reports and distinguish it from the "discrete" approach. 10. Describe and apply procedures used in interim reports for LIFO liquidations, costs associated with more than one interim period, income taxes, and accounting changes. 11. List the minimum disclosure requirements for interim financial reports. 8-5 Answer to Discussion Question In his well-publicized “The Numbers Game” speech delivered in September 1998, former SEC chairman Arthur Levitt cited “materiality” as one of five gimmicks used by companies to manage earnings. Although his remarks were not specifically directed toward the issue of geographic segment reporting, the intent was to warn the corporate America that materiality should not be used as an excuse for inappropriate accounting. To make the point even more salient, the SEC issued Staff Accounting Bulletin (SAB) 99, “Materiality,” in August 1999, which warns financial statement preparers that reliance on a simple numerical rule of thumb, such as 5% of net income, is not sufficient. SAB 99 reminds financial statement preparers that: “The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.” Further, SAB 99 reminds companies that both quantitative and qualitative factors should be considered in determining materiality. With respect to segment reporting, SAB 99 states: “The materiality of a misstatement may turn on where it appears in the financial statements. For example, a misstatement may involve a segment of the registrant's operations. In that instance, in assessing materiality of a misstatement to the financial statements taken as a whole, registrants and their auditors should consider not only the size of the misstatement but also the significance of the segment information to the financial statements taken as a whole. "A misstatement of the revenue and operating profit of a relatively small segment that is represented by management to be important to the future profitability of the entity" is more likely to be material to investors than a misstatement in a segment that management has not identified as especially important. In assessing the materiality of misstatements in segment information - as with materiality generally situations may arise in practice where the auditor will conclude that a matter relating to segment information is qualitatively material even though, in his or her judgment, it is quantitatively immaterial to the financial statements taken as a whole. Thus, in addition to quantitative factors, such as the relative percentage of total revenues generated in an individual foreign country, companies should consider qualitative factors as well. Qualitative factors that might be relevant in assessing the materiality of a specific foreign country include: the growth prospects in that country and the level of risk associated with doing business in that country. There are competing arguments for the FASB establishing a significance test for determining material foreign countries. On one hand, such a quantitative materiality test flies in the face of the warning provided in SAB 99. For example, a 10% of total revenue or long-lived asset test might give companies an excuse to avoid reporting individual countries that would be material for qualitative reasons. Assume that from one year to the next a company increases its revenues in China from 2% of total revenues to 6% of total revenues. Although 6% of total revenues would not meet a 10% test, the relatively large increase in total revenues generated in China could be material in that it could affect an investor’s assessment of the company’s future prospects. This company might be reluctant to disclose information about its revenues in China because of potential competitive harm. On the other hand, the FASB could establish a materiality threshold low enough, for example, 5% of total revenues, that would be likely to ensure that “material” countries are disclosed regardless of whether they are material for quantitative or qualitative reasons. A bright-line materiality threshold 8-6 Solutions Manual would ensure a minimum level of disclosure and would enhance the comparability of financial disclosures provided across companies. 8-7 Answers to Questions 1. Consolidation presents the account balances of a business combination without regard for the individual component companies that comprise the organization. Thus, no distinction can be drawn as to the financial position or operations of the separate enterprises that form the corporate structure. Without a method by which to identify the various individual operations, financial analysis cannot be well refined. 2. The word disaggregated refers to a whole that has been broken apart. Thus, disaggregated financial information is the data of a reporting unit that has been broken down into components so that the separate parts can be identified and studied. 3. According to SFAS 131, the objective of segment reporting is to provide information to help users of financial statements: a. better understand the enterprise’s performance, b. better assess its prospects for future net cash flows, and c. make more informed judgments about the enterprise as a whole. 4. Defining segments on the basis of a company’s organizational structure will remove much of the flexibility and subjectivity associated with defining industry segments under SFAS 14. In addition, the incremental cost of providing segment information externally should be minimal because that information is already generated for internal use. Analysts should benefit from this approach because it reflects the risks and opportunities considered important by management and allows the analyst to see the company the way it is viewed by management. This should enhance the analyst’s ability to predict management actions that can significantly affect future cash flows. 5. SFAS 131 defines an operating segment to be a component of an enterprise: a. that engages in business activities from which it earns revenues and incurs expenses, b. whose operating results are regularly reviewed by the chief operating decision maker to assess performance and make resource allocation decisions, and c. for which discrete financial information is available. 6. Two criteria must be considered in this situation to determine an enterprise’s operating segment. If more than one set of organizational units exists, but there is only one set for which segment managers are held responsible, that set constitutes the operating segments. If segment managers exist for two or more overlapping sets of organizational units, the organizational units based on products and services are defined as the operating segments. 8-8 Solutions Manual 7. The Revenue Test. An operating segment is separately reportable if its total revenues amount to 10 percent or more of the combined total revenues of all operating segments. The Profit or Loss Test. An operating segment is separately reportable if its profit or loss is 10 percent or more of the greater (in absolute terms) of the combined profits of all profitable segments or the combined losses of all segments reporting a loss. The Asset Test. An operating segment is separately reportable if its assets comprise 10 percent or more of combined assets of all operating segments. 8. For reportable operating segments, the following information must be disclosed: a. Revenues from sales to unaffiliated customers. b. Revenues from intercompany transfers. c. Profit or loss. d. Interest revenue. e. Interest expense. f. Depreciation, depletion, and amortization expense. g. Other significant noncash items included in profit or loss. h. Unusual items included in profit or loss. i. Income tax expense or benefit. j. Total assets. k. Equity method investments. l. Expenditures for long-lived assets. m. Description of the types of products or services from which the segment derives its revenues. 9. If operating segments are not based upon products or services, or a company has only one operating segment, then revenues from sales to unaffiliated customers must be disclosed for each of the company’s products and services. 10. Information must be provided for the domestic country, for all foreign countries in which the company generates revenue or holds assets, and for each foreign country in which the company generates a material amount of revenues or has a material amount of assets. 11. Two items of information must be reported for the domestic country, for all foreign countries in total, and for each foreign country in which the company has material operations: (1) revenues from external customers, and (2) long-lived assets. 12. The minimum number of countries to be reported separately is one: the domestic country. If no single foreign country is material, then all foreign countries would be combined and two lines of information would be reported; one for the United States and one for all foreign countries. SFAS 131 does not provide any guidelines related to the maximum number of countries to be reported. 13. The existence of a major customer and the related amount of revenues must be disclosed when sales to a single customer are 10 percent or more of consolidated sales. 14. U.S. publicly traded companies are required to prepare quarterly financial reports to provide investors and creditors with relevant information on a more timely basis than is provided by an annual report. 15. Companies are required to follow an "integral" approach in which each interim period is considered to be an integral part of an annual accounting period, rather than a "discrete" accounting period in its own right. For several items, the integral approach requires deviation 8-9 from the general rule that the same accounting principles used in preparing annual statements should also be used in preparing interim statements. 16. Cost-of-goods-sold should be adjusted in the interim period to reflect the cost at which the liquidated inventory is expected to be replaced, thus avoiding the effect of the LIFO liquidation on interim period income. 17. Income tax expense related to interim period income is determined by estimating the effective tax rate for the entire year. That rate is then applied to the cumulative pre-tax income earned to date to determine the cumulative income tax to be recognized to date. The amount of income tax recognized in the current interim period is the difference between the cumulative income tax to be recognized to date and the income tax recognized in prior interim periods. 18. When an accounting change occurs in other than the first interim period, information for the pre-change interim periods should be reported based on retrospective application of the new accounting principle. If retrospective application of the new accounting principle to pre-change interim periods is not practicable, the accounting change may be made only at the beginning of the next fiscal year. 19. The following minimum information must be disclosed in an interim report: a. Sales, income tax, extraordinary items, cumulative effect of accounting change, and net income. b. Earnings per share. c. Seasonal revenues and expenses. d. Significant changes in estimates or provisions for income taxes. e. Disposal of a business segment and unusual items. f. Contingent items. g. Changes in accounting principles or estimates. h. Significant changes in the following items of financial position: 1. Cash and cash equivalents. 2. Net working capital. 3. Long-term liabilities. 4. Stockholders' equity. 20. Four items of segment information are required to be included in interim reports: revenues from external customers, intersegment revenues, segment profit or loss, and total assets if there has been a material change in assets from the last annual report. 8-10 Solutions Manual Answers to Problems 1. D 2. C 3. A 4. C 5. B 6. D 7. C 8. A 9. B 10. B 11. C 12. C 13. C With regard to major customers, SFAS 131 only requires disclosure of the total amount of revenues from each such customer and the identity of the segment or segments reporting the revenues. 14. D 15. A 16. C 17. D 18. C If there has been a material change from the last annual report, total assets, but not individual assets, for each operating segment must be disclosed. 8-11 19. D Sales to outsiders Intersegment transfers Combined segment revenues 10% criterion Minimum $18,000 3,000 $21,000 x 10% $ 2,100 20. A Revenues from a single customer must be disclosed if the amount is 10 percent or more of consolidated sales. Consolidated sales only includes sales to outsiders; intersegment sales are eliminated. Consolidated sales (combined sales to outsiders) $376,000 10% criterion x 10% Minimum $ 37,600 21. D Total operating losses of $1,020,000 (K and M) are larger than total operating profits of $770,000. Thus, based on the 10 percent criterion, any segment with a profit or loss of $102,000 or more must be separately disclosed. K, O, and P do not meet that standard while L, M, and N do. 22. C Revenues Test Combined segment revenues 10% criterion Minimum $32,750,000 x 10% $ 3,275,000 Segments meeting test—A, B, C, E Profit or Loss Test Since there are no segments with a loss, this test is applied based on total combined segment profit. Combined segment profit $5,800,000 10% criterion x 10% Minimum $ 580,000 Segments meeting test—A, B, C, E Asset Test Combined segment assets 10% criterion Minimum $67,500,000 x 10% $ 6,750,000 Segments meeting test—A, B, C, D, E Five segments are separately reportable. 23. D 8-12 Solutions Manual 24. B The test to verify that a sufficient number of industry segments is being disclosed is based on revenues generated from unaffiliated customers. The four segments that are to be separately disclosed show outside sales of $520,000 out of a total for the company of $710,000. Since this portion is only 73.2 percent of the company’s total, the 75 percent criterion established by the FASB has not been met. 25. C $60,000 x 1/4 = $15,000 $120,000 x 1/4 = 30,000 $45,000 26. C Income as reported Less: Extraordinary loss (recognized in full in the interim period in which it occurs) Add: Cumulative effect loss (handled through adjustment of retained earnings balance at the beginning of the year) $100,000 (20,000) 16,000 $ 96,000 27. C $1,000,000 x 1/4 = $250,000 28. C $480,000 x 1/4 = $120,000 29. C Dr. Property Tax Expense Dr. Prepaid Property Taxes Cr. Cash 30. A 5,000 units x $80 = $400,000 300 units x $50 = 15,000 5,300 units $415,000 31. C 5,000 units x $80 = $400,000 300 units x $82 = 24,600 5,300 units $424,600 8-13 $120,000 360,000 $480,000 32. (10 minutes) (Apply the Profit or Loss Test to Determine Reportable Operating Segments) Calculation of profit or loss. Revenues Intersegment Operating from Outsiders Transfers Expenses Profit Cards $1,200,000 + $ 100,000 – $900,000 = $400,000 Calendars 900,000 + 200,000 – 1,350,000 = Clothing 1,000,000 – 700,000 = 300,000 Books 800,000 + 50,000 – 770,000 = 80,000 Total $ 780,000 Loss $250,000 $250,000 Any segment with an absolute amount of profit or loss greater than or equal to $78,000 (10% x $780,000) is separately reportable. Based on this test, each of the four segments must be reported separately. 8-14 Solutions Manual 33. (25 minutes) (Apply the Three Tests Necessary to Determine Reportable Operating Segments) Revenue Test (numbers in thousands) Segment Plastics Metals Lumber Paper Finance Total Revenues $ 6,425 2,294 738 455 186 $10,098 Percentage 63.7% (reportable) 22.7% (reportable) 7.3% 4.5% 1.8% 100.0% Profit or Loss Test (numbers in thousands) Segment Plastics Metals Lumber Paper Finance Total Revenues $ 6,425 2,294 738 455 186 Expenses $ 3,975 1,628 967 610 103 Profit $2,450 666 83 $3,199 Loss $ (reportable) (reportable) 229 155 $384 Since $3,199 is larger in absolute terms than $384, it will serve as the basis for testing. Each of the profit or loss figures will be compared to $319.90 (10% x $3,199). Asset Test (numbers in thousands) Segment Plastics Metals Lumber Paper Finance Total Assets $1,363 3,347 314 609 768 $6,401 Percentage 21.3% (reportable) 52.3% (reportable) 4.9% 9.5% 12.0% (reportable) 100.0% The plastics, metals, and finance segments meet at least one of the three tests and therefore are reportable. 8-15 34. (20 minutes) (A Variety of Computational Questions about Operating Segment and Major Customer Testing) a. Total revenues for Fairfield (including intersegment revenues) amount to $4,200,000. Minimum revenues for required disclosure are 10% or $420,000. b. Disclosure of operating segments is considered adequate only if the separately reported segments have sales to unaffiliated customers that comprise 75% or more of total consolidated sales. In this situation that requirement is met. Red, Blue, and Green have total sales to outsiders of $3,137,000 (or 86%) of total consolidated sales of $3,666,000. Thus, disclosure of these three segments would be adequate. c. Major customer disclosure is based on a level of sales to unaffiliated customers of at least 10% or, for Fairfield, $366,600 ($3,666,000 x 10%). d. This test is based on the greater (in absolute terms) of profits or losses. In this problem, the total profit of Red, Blue, Green, and White ($1,971,000) is greater than the total loss of Pink and Black ($316,000). Therefore, any segment with a profit or loss of $197,100 or more (10% x $1,971,000) is reportable. Using this standard, Red, Blue, Black, and White are of significant size. 8-16 Solutions Manual 35. (25 minutes) (Apply the Three Tests Necessary to Determine Reportable Operating Segments and Determine Whether a Sufficient Number of Segments is Reported) Revenue Test (numbers in thousands) Segment Books Computers Maps Travel Finance Total Revenues $ 205 936 455 432 184 $2,212 Percentage 9.3% 42.3% (reportable) 20.6% (reportable) 19.5% (reportable) 8.3% 100.0% Profit or Loss Test (numbers in thousands) Segment Revenues Books $ 205 Computers 936 Maps 455 Travel 432 Finance 184 Total $2,212 Expenses $ 218 899 400 314 132 $1,963 Profit Loss $ 13 $ 37 55 118 52 $262 $ 13 (reportable) (reportable) (reportable (reportable) This test is based on the greater (in absolute amount) of total profit from profitable segments or total loss from segments with a loss. In this case, any segment with profit or loss greater than or equal to $26,200 (10% x $262,000) is separately reportable. Asset Test (numbers in thousands) Segment Books Computers Maps Travel Finance Total 8-17 Assets $ 206 1,378 248 326 1,240 $3,398 Percentage 6.1% 40.5% (reportable) 7.3% 9.6% 36.5% (reportable) 100.0% 35. (continued) Test for Sufficient Number of Segments Being Reported Four of Mason’s segments (computers, maps, travel, and finance) meet at least one of the tests carried out above. To determine whether a sufficient number of segments is being reported, revenues from unaffiliated parties for these four segments must comprise at least 75% of total consolidated revenues. Consolidated revenues (sales to outside parties and interest income-external) for the company amount to $1,644. These four segments do make up over 75% (actually $1,463 or 89%) of this total. Therefore, this company is presenting disaggregated information for enough of its segments. Segment Computers Maps Travel Finance Total Sales to Outsiders $ 696 416 314 37 $1,463 36. (15 minutes) (Apply Materiality Tests Adopted by a Company to Determine Countries to be Reported Separately) Revenue Test (sales to unaffiliated parties) United States Spain Italy Greece Total $4,610,000 80.3% 395,000 6.9% 272,000 4.7% 463,000 8.1% $5,740,000 100.0% Long-lived Asset Test United States Spain Italy Greece Total $1,894,000 83.7% 191,000 8.4% 106,000 4.7% 72,000 3.2% $2,263,000 100.0% None of the individual foreign countries meets either the revenue or long-lived asset materiality test, so no foreign country must be reported separately. However, information must be presented for the United States separately and for all foreign countries combined. 8-18 Solutions Manual 37. (20 minutes) (Allocate Costs Incurred in One Quarter that Benefit the Entire Year and Determine Income Tax Expense) a. Determination of Income by Quarter—Estimated Annual Tax Rate 40% 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Sales $1,000,000 $1,200,000 $1,400,000 $1,600,000 Cost of goods sold (400,000) (480,000) (550,000) (600,000) Administrative costs (175,000) (180,000) (185,000) (195,000) Advertising costs (25,000) (25,000) (25,000) (25,000) Executive bonuses (20,000) (20,000) (20,000) (20,000) Provision for bad debts (13,000) (13,000) (13,000) (13,000) Annual maintenance costs (15,000) (15,000) (15,000) (15,000) Pre-tax income $352,000 $467,000 $592,000 $732,000 Income tax* (140,800) (186,800) (236,800) (292,800) Net income $211,200 $280,200 $355,200 $439,200 * Calculation of income tax by quarter: Pre-tax income this quarter $352,000 Cumulative pre-tax income $352,000 Estimated income tax rate x 40% Cumulative income tax to be recognized to date $140,800 Cumulative income tax recognized in earlier periods -0Income tax this quarter $140,800 $467,000 $592,000 $732,000 $819,000 $1,411,000 $2,143,000 x 40% x 40% x 40% $327,600 $564,400 $857,200 140,800 $186,800 327,600 $236,800 564,400 $292,800 b. Determination of Income by Quarter—Change in Estimated Annual Tax Rate Pre-tax income Income tax** Net income 8-19 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter $352,000 $467,000 $592,000 $732,000 (140,800) (186,800) (208,580) (278,160) $211,200 $280,200 $383,420 $453,840 37. (continued) ** Calculation of income tax by quarter: Pre-tax income this quarter $352,000 Cumulative pre-tax income $352,000 Estimated income tax rate x 40% Cumulative income tax to be recognized to date $140,800 Cumulative income tax recognized in earlier periods -0Income tax this quarter $140,800 $467,000 $592,000 $732,000 $819,000 $1,411,000 $2,143,000 x 40% x 38% x 38% $327,600 $536,180 $814,340 140,800 $186,800 327,600 $208,580 536,180 $278,160 38. (15 minutes) (Treatment of Accounting Change Made in Other than First Interim Period) Retrospective application of the FIFO method results in the following restatements of income for 2008 and the first quarter of 2009: 2008 st 1 Q. Sales Cost of goods sold (FIFO) Operating expenses Income before income taxes Income taxes (40%) Net income 2 nd rd Q. 3 Q. 2009 th 4 Q. 1st Q. $10,000 $12,000 $14,000 $16,000 $18,000 3,800 2,000 4,200 1,680 $2,520 4,600 2,200 5,200 2,080 $3,120 5,200 2,600 6,200 2,480 $3,720 6,000 3,000 7,000 2,800 $4,200 7,400 3,200 7,400 2,960 $4,440 Net income in the second quarter of 2009 is $4,560 [$20,000 – 9,000 – 3,400 = $7,600 – 3,040 (40%) = $4,560]. The accounting change is reflected in the second quarter of 2009, with year-todate information, and comparative information for similar periods in 2008 as follows: Net income Net income per common share Three Months Ended June 30 2008 2009 $3,120 $4,560 $3.12 $4.56 Six Months Ended June 30 2008 2009 $5,640 $9,000 $5.64 $9.00 8-20 Solutions Manual 39. (10 minutes) (LIFO Liquidation in Interim Report) Determination of Cost-of-Goods-Sold and Gross Profit Sales (110,000 units @ $20) Cost-of-goods-sold 100,000 units @ $14 10,000 units @ $15 (replacement cost) Gross profit $2,200,000 $1,400,000 150,000 1,550,000 $650,000 Journal Entries to Record Sales and Cost-of-Goods-Sold Dr. Cash or accounts receivable Cr. Sales revenue Dr. Cost-of-goods-sold Cr. Inventory Cr. Excess of replacement cost over historical cost of LIFO liquidation $2,200,000 $1,550,000 $2,200,000 $1,520,000 30,000 To record cost-of-goods-sold with a historical cost of $1,520,000 and an excess of replacement cost over historical cost for beginning inventory liquidated of $30,000 (($15 – $12) x 10,000 units). 8-21 Answers to Develop Your Skills Cases Research Case 1—Segment Reporting This assignment requires the student to select a company and find the note on operating segments in that company’s annual report. The responses to this assignment will depend upon the company selected by the student for analysis. Research Case 2—Interim Reporting This assignment requires students to select a company, find the most recent quarterly report for that company, and then determine whether the company provides the minimum disclosure required by APB Opinion 28 as listed in the text. The responses to this assignment will depend upon the company selected by the student for analysis. Research Case 3—Operating Segments This assignment requires students to find the note on operating segments in each company's annual report, determine three items of information (answer three questions) from those notes, and prepare a written summary of their findings. The primary objective of this requirement is to help students develop their ability to present such findings in a written format. In answering these questions, students will become familiar with the different formats and terminology used by companies in providing operating segment information. The answers to these questions will change depending upon the most recent annual report available on the company’s website. The following general observations indicate how these questions might be answered. 1. The answer to this question is determined by calculating the ratio ―segment revenues/total segment revenues‖ for each segment of each company. Different terms can be used for revenues including net sales and net sales to external customers. Companies are required to disclose both revenues from sales to external customers and revenues from intersegment sales. This question should be answered using revenues from sales to external customers if reported separately. In 2006, four of the five companies defined operating segments on the basis of products/services. However, Cisco Systems identified its operating segments as geographic areas. 2. This question is answered by calculating the ratio ―(current year segment revenues – previous year segment revenues)/previous year segment revenues‖ for each segment of each company. 3. This question is answered by calculating the ratio ―segment profit/segment revenues‖ for each segment of each company (again using revenues from sales to external customers if separately reported). Segment profit goes under a variety of names including operating earnings, income 8-22 Solutions Manual from continuing operations, standard margin, and operating profit. Cisco Systems uses gross margin by segment in making decisions. Some companies might provide information for more than one measure of profit, e.g., income before income taxes and income from continuing operations, in which case the instructor might wish to indicate which measure of profit to consider in answering this question. There is no right or wrong measure of profit to use. General Electric does not include segment profit in its operating segment note, but instead (in 2006) refers the reader to a ―Summary of Operating Segments‖ table on page 40 of the annual report, which is part of Management's Discussion and Analysis. After reviewing the information provided by each of these companies in its segment footnote, instructors might wish to add additional questions to this assignment. For example, do these companies use generally accepted accounting principles in preparing segment information? Does each company provide a reconciliation to consolidated totals? Research Case 4—Comparability of Geographic Area Information This assignment requires students to find the note on geographic areas in each company's annual report and then prepare a report describing the comparability of this information. In preparing this assignment, students will see the different formats used by companies in providing this information, and the different levels of detail on geographic areas provided. The comparability of this information will change depending upon the most recent annual report available on the company’s website. The following comparison based upon the 2006 annual reports represents the type of analysis students might perform in solving this assignment. Geographic Areas Reported by Four Pharmaceutical Companies—2006 Bristol-Myers Squibb Eli Lilly Merck Pfizer U.S. U.S. U.S. U.S. Europe/MidEast/Africa E/ME/A E/ME/A Other Western Hemi. Pacific Japan Japan Other Other All Other The only geographic area that can be directly compared across these four pharmaceutical companies is the United States. Bristol-Myers Squibb provides more detailed (and perhaps more useful) information than the other companies. Only Merck and Pfizer reports an individual country (Japan) other than the U.S. Issues that could be discussed include different quantitative thresholds used by companies in determining what is a material country, and the fact that disclosure of geographic areas aggregated above the individual country level 8-23 (e.g., E/ME/A, Pacific) is not required by SFAS 131. One can assume that BristolMyers Squibb does not have a material amount of revenues or assets in any single country and voluntarily provides information on a more aggregated, regional basis. Pfizer, on the other hand, has elected not to provide such voluntary information, only reporting individual countries (Japan) and ―all other countries.‖ Research Case 5—Within Industry Comparison of Segment Information The purpose of this assignment is to show students how segment information can be used to gain insights into the nature and location of a company’s operations, and give them an opportunity to compare and contrast this information for two companies in the same industry. The responses to this assignment will depend upon the companies selected by the student for analysis. Students should discuss both the operating segments and geographic areas in which the companies operate. They might discuss the extent to which the two companies compete with each other in terms of product lines or geographic areas, as well as the extent to which this information can be compared. For example, if one company defines operating segments on the basis of products and another company in the same industry defines operating segments geographically, meaningful comparisons between the two companies will be difficult to make. 8-24 Solutions Manual FARS Case 1—Interim Reporting 1. Using the advanced query function in FARS to search for the phrase ―material seasonal variations‖ returns two hits: APBO 28, paragraph 18, and the dissent to APBO 28 by one member of the Board. 2. APBO 28, paragraph 18 requires firms with material seasonal variations to disclose this fact to avoid the possibility that interim results with material seasonal variations are taken as indicative of the estimated results for a full year. FARS Case 2—Segment Reporting 1. Using the advanced query function in FARS to search for the phrases ―competitive harm‖ and ―segments‖ returns five hits: FAS 131, paragraphs 74, 75, 97, 109, and 111. 2. FAS 131, paragraph 109 indicates that concerns were raised about publicly traded companies being at a disadvantage compared to nonpublic companies or foreign competitors who do not have to disclose segment information, and that segment information might put a company at a disadvantage in price negotiations with customers or in competitive bidding situations. 3. FAS 131, paragraph 111 indicates that the FASB decided not to provide a competitive harm exemption because it would provide a means for noncompliance with FAS 131. 4. FAS 131, paragraph 97 describes three reasons why the FASB decided not to require the disclosure of research and development expense by segment. First, it might result in competitive harm by providing competitors with early insight into a company’s strategic plans. Second, research and development is only one item that indicates where a company is focusing its efforts and is more significant for some companies than for others. Third, research and development activities often are centralized and not allocated to segments. 8-25 Analysis Case 1—Airline Industry Interim Reporting The purpose of this assignment is to show how interim reports can provide more timely information about significant economic events than annual reports. The responses to this assignment will depend upon the company selected by the student for analysis. Delta Air Lines, Inc., provided the following types of information in its interim report for the quarter ended September 30, 2001.    In ―Forward-Looking Statements,‖ the company listed ―the many effects on Delta and the airline industry from the terrorist attacks on the United States…‖ In ―Note 1: Accounting and Reporting Policies,‖ the company stated ―Due to seasonal variations in the demand for air travel and other factors, including the September 11 terrorist attacks described in Note 2 below, operating results for the interim period are not necessarily indicative of operating results for the entire year.‖ In ―Note 2: September 11, 2001 Events,‖ the company discusses (1) increased costs resulting from new FAA regulations, (2) financial implications for the company from the Air Transportation Safety and System Stabilization Act, and (3) its decision to reduce capacity and costs related to the resulting reduction in staff. The income statement reflects the financial impact from the disruption of air travel subsequent to September 11. Delta experienced a 22% decline in operating revenues in 3Q 2001 compared to the same quarter in the previous year, and reported a loss of $259 million in 3Q 2001 as opposed to net income of $133 for the same quarter in 2000. 8-26 Solutions Manual Analysis Case 2—Wal-Mart Interim and Segment Reporting 1. Not surprisingly, Wal-Mart experienced a significant increase in net sales and net income in the quarter ended January 31, which includes the holiday season, over the previous three quarters of the year (see Note 12). Operating income for the quarter ended January 31 can be determined for each segment by subtracting the amounts reported in the three quarterly reports from the amounts reported in Note 11. Operating Income Wal-Mart Stores SAM'S CLUB Fiscal Year Ended January 31, 2006 $ 15,324 $ 1,385 Quarter Ended April 30, 2005 3,307 295 667 Quarter Ended July 31, 2005 3,992 371 750 Quarter Ended October 31, 2005 3,312 342 797 Quarter Ended January 31, 2006 $ 4,713 $ 377 International $ $ 3,330 1,116 These results show the seasonal nature of the company’s two largest segments (Wal-Mart and International), with the quarter ended January 31 generating a larger amount of operating income. 2. Note 12 can be used to assess profitability in terms of profit margin (Net income/Net sales) by quarter. Amounts in millions 2005/2006 Net income Net sales Net income/Net sales April 30 $ 2,461 70,908 3.47% Quarter Ended July 31 October 31 January 31 $ 2,805 $ 2,374 $ 3,589 76,811 75,436 89,273 3.65% 3.15% 4.02% These results indicate that profit margins are highest in the fourth quarter of the year, the quarter with the largest percentage of total sales. Note 11 can be used to assess profitability in terms of operating profit margin (Operating income/Revenues) and return on assets (Operating income/Total assets) by segment. 8-27 Fiscal year ended January 31, 2005 Operating income (loss) Revenues from external customers Operating income/Revenues Wal-Mart SAM’S Stores CLUB $ 15,324 $ 1,385 209,910 39,798 7.30% 3.48% International $ 3,330 62,719 5.31% Operating income (loss) Total assets of continuing operations Operating income/Total assets $ 15,324 32,809 46.71% $ 3,330 51,581 6.46% $ 1,385 5,686 24.36% These results indicate that Wal-Mart Stores by far is the most profitable segment for the Wal-Mart Company. Although the International segment has a reasonable Operating Profit Margin, that segment’s Return on Assets is very low. Return on Assets must be interpreted with caution, however, because the ending balance in Total Assets is used in the denominator of the ratio rather than the average amount of Total Assets for the year. The International segment’s Return on Assets (6.46%) is understated to the extent that a significant portion of Total Assets were acquired late in the year. 8-28 Solutions Manual Excel Case 1—Altria Group Operating Segment Information 1. The ratios required to be calculated for Altria Group, Inc. are as follows: Percentage of total net revenues Domestic tobacco International tobacco North American food International food Financial services Total 2005 18.53% 46.28% 23.80% 11.06% 0.33% 100.00% Percentage change in total net revenues Domestic tobacco International tobacco North American food International food Financial services Percentage of total operating companies income Domestic tobacco International tobacco North American food International food Financial services Total Operating companies income as a percentage of net revenues (profit margin) Domestic tobacco International tobacco North American food International food Financial services 2004 19.54% 44.12% 24.62% 11.28% 0.44% 100.00% 2004-2005 3.56% 14.55% 5.59% 7.04% -19.24% 2005 26.34% 45.00% 22.03% 6.45% 0.18% 100.00% 2004 27.67% 41.25% 24.31% 5.86% 0.90% 100.00% 2005 25.26% 17.28% 16.45% 10.37% 9.72% 2004 25.16% 16.61% 17.54% 9.23% 36.46% 2. In 2005, Altria’s most profitable segment was Domestic Tobacco, followed by International Tobacco, and then North American food. International tobacco contributes the greatest percentage of total revenues and total operating income. International food has the smallest percentage of net revenues and operating income, and is the least profitable segment. International tobacco experienced the greatest rate of growth in net revenues from 2004 to 2005. The other segments experienced low growth with Domestic tobacco growing only 3.5%. 8-29 3. Altria’s tobacco operations (domestic and international) comprised approximately 65% of net revenues and 71% of operating income in 2005. These percentages have increased from 2004 to 2005. At the same time, the percentage of total revenues and operating income generated by food (especially North American) has decreased from 2004 to 2005. The company appears to be increasing its emphasis on tobacco operations, especially internationally. The low growth in revenues in Domestic tobacco may be partially attributable to the legal problems experienced in the United States. Given these legal difficulties, a shift from Domestic tobacco to International tobacco could have a positive effect on the company’s future success. 8-30 Solutions Manual Excel Case 2—Coca-Cola Geographic Segment Information 1. The ratios required to be calculated for the Coca-Cola Company are as follows: Percentage of total net operating revenues North America Africa East, South Asia and Pacific Rim European Union Latin America North Asia, Eurasia and Middle East Total Percentage growth in net operating revenues North America Africa East, South Asia and Pacific Rim European Union Latin America North Asia, Eurasia and Middle East Operating income as a percentage of net operating revenues (profit margin) North America Africa East, South Asia and Pacific Rim European Union Latin America North Asia, Eurasia and Middle East 2005 29.00% 5.49% 5.46% 29.55% 10.98% 19.52% 100.00% 2004 29.68% 4.93% 5.90% 30.36% 9.81% 19.32% 100.00% 2004-2005 3.94% 18.37% -1.41% 3.55% 19.03% 7.46% 2003-2004 4.32% 29.02% -4.13% 7.95% 3.97% -3.22% 2005 23.28% 32.86% 15.98% 33.03% 47.76% 38.03% 2004 25.00% 31.87% 26.96% 27.58% 50.35% 38.95% 2. There is no right or wrong answer to this question. Students could argue that Latin America would be the area of the world in which to expand because profit margin is highest in this area. There would also seem to be more room to expand in Latin America given that this area has a relatively small percentage of total revenues. East, South Asia, and Pacific Rim is the only area in which the company has experienced a decline in revenues in 2004 and 2005. This is the region in which the company has the smallest percentage of total revenues and it also is the area with the smallest profit margin (in 2005). Perhaps this is the area in which the company should concentrate its efforts, especially because the 8-31 company does not appear to be very successful there. 3. There is a great deal of non-accounting information that one would need to determine a specific region of the world in which to focus expansion. For example, one might need to gather information to answer the following questions:     Is there a sufficiently large population with enough disposable income to be able to purchase the company’s products? Are raw materials available locally? Is there a well-developed transportation infrastructure that would allow the products to be brought to consumers at a reasonable cost? Do local customs, culture, religion, etc. affect drinking habits, especially the consumption of soft drinks? 8-32 Solutions Manual