Question

essay questions:

1. Discuss what is Net Reporting and give an example of a company that may use it. Justify your example. (Chapter 4, Section 3.2.4)

2. Why is it important for analysts that Discontinued Operations be listed separately in a company’s financial statements? Give examples where appropriate. (Chapter 4, Section 5.2)

3. Describe the scope of financial statement analysis and discuss some examples of uses for investors. (Chapter 1, Section 2, p2-3)

Answer 1

1.Net Reporting :

Recording revenue at gross means that you record the revenue from a sale transaction on the income statement. Recording revenue at net usually means that you’re only recording a commission on a sale transaction as the entire amount of revenue. If there isn’t strictly a commission, you can still report revenue at net by netting the amount billed to the customer against the amount paid to the supplier.

There are many situations that fall into a gray area where revenue could be reportable at gross or it could be reportable at net. This is a major issue for a business, which will probably want to record revenues at gross in order to give the appearance of a larger entity, especially if it is about to be sold to an acquirer that will pay more based on the sales volume of the business.

, "Reporting Revenue Gross as a Principal Versus Net as an Agent.” Please note that these are guidelines, so recording at gross or net is a matter of judgment.

Several guidelines that point you in the direction of reporting revenues at net. They are:

1. The amount you earn is fixed. This indicates a commission structure, which is sometimes set up as a fixed payment per customer transaction. If you earn a percentage of what the customer pays, this is also an indicator that you report revenue at net. In either case, you’re really just an agent for someone else.

2. The other two guidelines for reporting at net are just the reverse side of some earlier guidelines. If a supplier has credit risk, or if a supplier is responsible for providing products or services to the customer, then you’re probably looking at reporting revenue at net.

For most companies, you can pretty easily pick which guidelines apply to you, and in most cases you probably record your revenue at gross. But here are some considerations to think about:

• You run an Internet store, and you collect money from customers, and then instruct a supplier to ship the goods to the customer. In this case, you have credit risk, so there’s an indication that you can probably record revenue at gross. And in fact, most Internet stores do. But what if there’s also a statement on the website that the website operator only accepts orders on behalf of suppliers, and the operator is not responsible for any problems with shipments? Chances are, you’re now looking at net revenue reporting.

• You develop specifications for custom products with the customer, and then you find a supplier who can make it. In this case, you can record revenue at gross, because you have credit risk and you get to pick the supplier.

• You’re a travel discounter, and you negotiate with the airlines for reduced prices. You then advertise the reduced rates to the public. You bill the customer, and you’re responsible for delivering the ticket to the customer. But – once the customer receives the ticket, the airline is responsible for all subsequent service. There’s no inventory risk and the primary obligor is the airline, which points you toward net reporting. On the other hand, you can set the price and you bear the credit risk, which tends to point toward gross reporting.

2.Importance for analysts that Discontinued Operations be listed separately in a company’s financial statements

Discontinued operations are listed separately on the income statement because it's important that investors can clearly distinguish the profits and cash flows from continuing operations from those activities that have ceased. This distinction is especially useful when companies merge, as parsing out which assets are being divested or folded gives a clearer picture of how a company will make money in the future.

On a company's income statement, discontinued operations are segregated from continuing operations so that investors may see clearly what money is inflowing from current operations versus those which have ceased.

Disclosure on Income Statements

When operations are discontinued, a company has multiple line items to report on its financial statements. Although the business component is being shut down, it still could generate a gain or loss in the current accounting period.

The total gain or loss from the discontinued operations is thus reported, followed by the relevant income taxes. This tax is often a future tax benefit because discontinued operations often incur losses. To determine the company's total net income (NI), the gain or loss from discontinued operations is aggregated with that of continuing operations.

So as not to confuse adjustments to the financial statements that relate to previously reported discontinued operations, a company may classify the adjustments separately in the discontinued operations section of its financials. Adjustments may occur because of benefit plan obligations, contingent liabilities, or contingent contract terms.

If the buyer of a discontinued operation assumes the debt associated with the operation, any interest expense before the sale is allocated to discontinued operations. Generally accepted accounting principles (GAAP) do not allow general corporate overhead to be allocated to discontinued operations.

KEY TAKEAWAYS

• Discontinued operations is an accounting term that refers to parts of a company’s core business or product line that have been divested or shut down.
• Discontinued operations are reported on the income statement separately from continuing operations.
• When companies merge, understanding which assets are being divested can give a clearer picture of how a company will make money in the future.

Discontinued Operations Under GAAP

A company may report discontinued operations under GAAP as long as two conditions are met. First, the transaction to shut down the divested business will result in eliminating the operations and cash flows of the divested business from company operations. Second, once it has been discontinued, the closed business must have no significant ongoing involvement with its operations. If these two conditions are met, then a company may report discontinued operations on its financial statements.

Discontinued Operations Under IFRS

International financial reporting standards (IFRS) reporting rules differ slightly from GAAP. A discontinued operation must meet two criteria. First, the asset or business component must be disposed of or reported as being held for sale. Second, the component must be distinguishable as a separate business that is being removed from operation intentionally or a subsidiary of a component being held with the intent to sell.

Unlike GAAP reporting requirements, IFRS rules permit equity method investments to be classified as held for sale. Moreover, under IFRS entities may continue involvement with the discontinued operation. As with GAAP, discontinued operations are reported in a special section of the income statement.

Ned owns and runs Ned’s Networks, a company consisting of six television channels. One channel, a specialty network devoted to everything fitness, has been a money loser. In the 18 months it has been on the air, it has only generated a profit once, and it was a small one. There’s just not enough interest from the viewing public to generate the advertising revenues Ned needs. He decides, after going over the latest financial reports and meeting with his senior team, to shut down the channel.

Eight people work specifically for this channel, four in content, two in programming and two in sales. Ned is able to assign four of them to other channels that need help, but four of the staff are let go.

Ned instructs accounting to discontinue operations for this channel. This means that any income or expenses related to the channel’s operation will now fall under “Discontinued Operations” on the income statement (the one that will be generated for the same quarter he sold the station in). In Ned’s case, these amounts include sale revenues from ads, the cost of the severance packages, taxes, licensing fees, programming charges, interest expenses, etc.

Now let’s try another scenario. Ned decides to simply sell the channel.

Upon selling it, Ned instructs accounting to discontinue operations for this channel. There will still be the same income and expenses as per the first scenario, but there will also be charges related to the physical transfer of some of the channel’s equipment to the new location, as per the agreement he has in place with the buyer. These costs will also be reflected under “Discontinued Operations” on the next income statement.

3.Scope of financial statement analysis

Meaning of Financial Statement Analysis:

The term ‘financial analysis’, also known as analysis and interpretation of financial statements’, refers to the process of determining financial strengths and weaknesses of the firm by establishing strategic relationship between the items of the balance sheet, profit and loss account and other operative data.

“Analyzing financial statements,” according to Metcalf and Titard, “is a process of evaluating the relationship between component parts of a financial statement to obtain a better understanding of a firm’s position and performance.”

The role of financial statement analysis is to use the financial reports prepared by firms and combine it with other sources of information to decide if you can invest in the equity of the firm or lend money to the firm.

The purpose of financial analysis is to diagnose the information contained in financial statements so as to judge the profitability and financial soundness of the firm. Just like a doctor examines his patient by recording his body temperature, blood pressure, etc. before making his conclusion regarding the illness and before giving his treatment, a financial analyst analysis the financial statements with various tools of analysis before commenting upon the financial health or weaknesses of an enterprise.

The analysis and interpretation of financial statements is essential to bring out the mystery behind the figures in financial statements. Financial statements analysis is an attempt to determine the significance and meaning of the financial statement data so that forecast may be made of the future earnings, ability to pay interest and debt maturities (both current and long-term) and profitability of a sound dividend policy.

The term ‘financial statement analysis’ includes both ‘analysis’, and ‘interpretation’. A distinction should, therefore, be made between the two terms. While the term ‘analysis’ is used to mean the simplification of financial data by methodical classification of the data given in the financial statements, ‘interpretation’ means, ‘explaining the meaning and significance of the data so simplified.’

However, the following purposes or objectives of financial statements analysis may be stated to bring out the significance of such analysis:

i) To assess the earning capacity or profitability of the firm.

(ii) To assess the operational efficiency and managerial effectiveness.

(iii) To assess the short term as well as long term solvency position of the firm.

(iv) To identify the reasons for change in profitability and financial position of the firm.

(v) To make inter-firm comparison.

(vi) To make forecasts about future prospects of the firm.

(vii) To assess the progress of the firm over a period of time.

(viii) To help in decision making and control.

The utility of financial statements to different parties is discussed in detail as follows:

(1) Management:

The financial statements are useful for assessing the efficiency for different cost centres. The management is able to exercise cost control through these statements. The efficient and inefficient spots are brought to the notice of the management. The management is able to decide the course of action to be adopted in future.

(2) Creditors:

The trade creditors are to be paid in a short period. This liability is met out of current assets. The creditors will be interested in current solvency of the concern. The calculation of current ratio and liquid ratio will enable the creditors to assess the current financial position of the concern in relation to their debts.

(3) Bankers:

The banker is interested to see that the loan amount is secure and the customer is also able to pay the interest regularly. The banker will analyze the balance sheet to determine financial strength of the concern and profit and loss account will also be studied to find out the earning position.

A banker has a large number of customers and it is not possible to supervise their business activities. It is through the financial statements that a banker can keep a watch on the business plans and performances of its customers. These statements also help the banker to determine the amount of securities it will ask from the customers as a cover for the loans.

(4) Investors:

The investors include both short-term and long-term investors. They are interested in the security of the principal amount of loan and regular interest payments by the concern. The investors will study the long-term solvency of the concern with the help of financial statements. The investors will not only analyze the present financial position but will also study future prospects and expansion plans of the concern. The possibility of paying back the loan amount in the face of liquidation of the concern is also taken into consideration.

(5) Government:

The financial statements are used to assess tax liability of business enterprises. The government studies economic situation of the country from these statements. These statements enable the government to find out whether business is following various rules and regulations or not. These statements also become a base for framing and amending various laws for the regulation of business.

(6) Trade Associations:

These associations provide service and protection to the members. They may analyze the financial statements for the purpose of providing facilities to these members. They may develop standard ratios and design uniform system of accounts.

(7) Stock Exchange:

The stock exchanges deal in purchase and sale of securities of different companies. The financial statements enable the stock brokers to judge the financial position of different concerns. The fixation of prices for securities, etc., is also based on these statements.