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Chapter 10 - Other Items That Affect Net Income and Owners Equity

CHAPTER 10
OTHER ITEMS THAT AFFECT
NET INCOME AND OWNERS 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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Chapter 10 - Other Items That Affect Net Income and Owners Equity

Problems
Problem 10-1
Wages Payable
Cash
FICA Taxes Payable
Withholding Taxes Payable
And, to finish, payment to government:
FICA Taxes Payable
Unemployment Taxes Payable
Withholding Taxes Payable
Cash

1,025.00
776.35
74.65
174.00
149.30
40.05
174.00
363.35

Problem 10-2

dr. Pension Cost..............................................................................................................................................................................


85,000
cr. Cash........................................................................................................................................................................................
40,100
Pension Liability.....................................................................................................................................................................
44,900
Problem 10-3

Financial Statements (Accrual Basis)


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

Tax Return (Cash Basis)


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

2007
2008
2009
2010
Tax provision..................................................................................................................................................................................
$55,800
$ 7,200
$ 12,600
$48,600
Tax payment....................................................................................................................................................................................
14,400
32,400
43,200
25,200
Difference.......................................................................................................................................................................................
41,400
(25,200)
(30,600)
23,400
Cumulative 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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Chapter 10 - Other Items That Affect Net Income and Owners Equity

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
2010
2011
2012
2013
2014
2015

Cost
$2,750,000
2,750,000
2,750,000
2,750,000
2,750,000
2,750,000

Depreciation
Expense
$275,000
550,000
550,000
550,000
550,000
275,000

Cumulative
Depreciation
Allowance
$ 275,000
825,000
1,375,000
1,925,000
2,475,000
2,750,000

Net Book Value


$2,475,000
1,925,000
1,375,000
825,000
275,000
-0-

Depreciation
Deduction
$550,000
880,000
528,000
316,250
316,250
159,500

Cumulative
Depreciation
Deduction
$ 550,000
1,430,000
1,958,000
2,274,250
2,590,500
2,750,000

Net Tax Basis


$2,200,000
1,320,000
792,000
475,750
159,500
-0-

Net tax basis of machinery for tax purpose.

Year
2010
2011
2012
2013
2014
2015

Tax Basis
$2,750,000
2,750,000
2,750,000
2,750,000
2,750,000
2,750,000

Deferred Tax Liability Calculation


Year
2010
2011
2012
2013
2014
2015

Net Book Value


$2,475,000
1,925,000
1,375,000
825,000
275,000
-0-

Year
2010
2011
2012
2013
2014
2015

Profit Before
Depreciation
$1,500,000
1,500,000
1,500,000
1,500,000
1,500,000
1,500,000

Net Tax Basis


$2,200,000
1,320,000
792,000
475,750
159,500
-0-

Difference
$275,000
605,000
583,000
349,250
115,500
-0-

Deferred Tax
Liability
$110,000
242,000
233,200
139,700
46,200
-0-

Taxable Income
$ 950,000
620,000
972,000
1,183,750
1,183,750
1,340,500

Tax Payment
$380,000
248,000
388,800
473,500
473,500
536,200

Income Tax Payments


Depreciation
$550,000
880,000
528,000
316,250
316,250
159,500
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Chapter 10 - Other Items That Affect Net Income and Owners Equity

Income Tax Provisions


Year
2010
2011
2012
2013
2014
2015

2010
2011
2012
2013
2014
2015

Profit before
Depreciation
$1,500,000
1,500,000
1,500,000
1,500,000
1,500,000
1,500,000

Depreciation
$275,000
550,000
550,000
550,000
550,000
275,000

Pretax Income
$1,225,000
950,000
950,000
950,000
950,000
1,225,000

Tax Provision Presentation


Current
Deferred
Tax Expense
Tax Expense
$380,000
$110,000
248,000
132,000
388,800
(8,800)
473,500
(93,500)
473,500
(93,500)
536,200
(46,200)

Tax Provision
$490,000
380,000
380,000
380,000
380,000
490,000

Total Tax
Provision
$490,000
380,000
380,000
380,000
380,000
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,XXX
Extraordinary item, net
of applicable income
taxes ($90,000).............................................................................................................
210,000
Net income
$XXX,XXX

Problem 10-6
a. and b.

c.

1.

dr. Inventory...........................................................................................................................................
57,600
cr. Note Payable..................................................................................................................................
57,600

2.

dr. Note Receivable................................................................................................................................


2,700
cr. Sales...............................................................................................................................................
2,700

3.

dr. Accounts Receivable.........................................................................................................................


720,000
cr. Sales...............................................................................................................................................
720,000

4.

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

1.

Note Payable (year end).........................................................................................................................


$ 60,000
Note Payable (transaction date)..............................................................................................................
57,600
Exchange loss....................................................................................................................................
$ 2,400

2.

Note receivable (year end).....................................................................................................................


$ 3,000
Note receivable (transaction date)..........................................................................................................
2,700
Exchange gain....................................................................................................................................
$ 300

3.

Account receivable (year end)................................................................................................................


$692,308
Account 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
Tax
Sales....................................................................................................................................................................................
$1,000
$900
Cost of sales @ 70%...........................................................................................................................................................
700
630
Gross margin.......................................................................................................................................................................
300
270
Other expenses....................................................................................................................................................................
200
200
Pretax income......................................................................................................................................................................
100
70
Income tax expense @ 34%................................................................................................................................................
34
23.8
Actual taxes as percent of pretax Book income...............................................................................................................
34%
23.8%
Cash (or Taxes
Payable)
23.8

Income Tax
Expense
34

Deferred
Taxes
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 Silvers taxes would
have been in 2005-10 and that taxes would have been higher in 2010 using the installment method. Line 9
shows each years year-end balance of Deferred Taxes; again, note that the reversal in 2010 causes the
balance to decrease.

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Chapter 10 - Other Items That Affect Net Income and Owners Equity

Exhibit A
SILVER APPLIANCE COMPANY
(In Thousands)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
1
2

2006
2007
2008
2009
2010
Year-end installment receivables....................................................................................................................................
$190.1
$351.9
$526.2
$559.4
$489.1
Gross margin %..............................................................................................................................................................
34.6%
35.1%
34.2%
33.4%
32.2%
Deferred gross margin (= 1 * 2)......................................................................................................................................
65.77
123.52
179.96
186.84
157.49
Pretax profit, delivery basis............................................................................................................................................
332.6
415.3
478.2
492.5
461.3
Income taxes, delivery basis (34% of 4).........................................................................................................................
113.08
141.20
162.59
167.45
156.84
Pretax profit, installment basis (= 4 - 3 +
previous years 3) 47.31.................................................................................................................................................
266.83
357.55
421.76
485.62
490.65
Income taxes, installment basis (34% of 6)....................................................................................................................
90.72
121.57
143.40
165.11
166.82
Tax deferred (5 - 7).........................................................................................................................................................
22.361
19.632
19.19
2.34
(9.98)
Cumulative tax deferred.................................................................................................................................................
22.36
41.99
61.18
63.52
53.54

Liability method calculations is Line 3 ($65.77) times 34 percent.


Liability 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 APBs 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 years credits (new payables or deferrals) exceed that years debits (accounts paid or
deferral reversals). Indeed 2010s 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. Silvers architect friend, Silvers 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 8s 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 years 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 managements 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 companys 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 markets 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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Chapter 10 - Other Items That Affect Net Income and Owners Equity

Exhibit A
Net Investment Translation Method
(won in millions, dollars in thousands)
Freedom-Korea
Balance Sheet as of September 30, 20x2

Assets
Won
Exchange Rate
Dollars
Cash................................................................................................................................................................................................
W591
$0.00124
$ 732.8
Receivables.....................................................................................................................................................................................
1,182
0.00124
1,465.7
Inventories......................................................................................................................................................................................
552
0.00124
684.5
Fixed assets ....................................................................................................................................................................................
575
0.00124
713.0
W2,900
$3,596.0
Liabilities and Owners Equity
Current liabilities.............................................................................................................................................................................
W624
0.00124
$ 773.8
Capital stock....................................................................................................................................................................................
1,000
0.00140
1,400.0
Retained earnings............................................................................................................................................................................
1,276
(see below)
1684.3
Accum. translation adjustments......................................................................................................................................................
---*
(262.1)
W2,900
$3,596.0

Income Statement for the year ended September 30, 20x2


Revenues.........................................................................................................................................................................................
W7,090
$0.00132
$9,358.8
Cost of sales ...................................................................................................................................................................................
4,415
0.00132
5,827.8
Other expenses................................................................................................................................................................................
1,399
0.00132
1,846.7
Net 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...........................................................................................................
$ 1,240.0
Translated at Oct. 1, 20xl rate = 1,000 * 0.00140................................................................................................................
1,400.0
Loss on beginning-of-year net assets...................................................................................................................................
$ (160x.0)

Increment in net assets during FT 20x2 = W 1,276


Translated at Sept 30,20x2 rate = 1,276 * $0.00124............................................................................................................
$1,582.2
Translated at average FY 20x2 rate = 1,276 * 0.00132........................................................................................................
1,684.3
Loss 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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Chapter 10 - Other Items That Affect Net Income and Owners Equity

Exhibit B
Monetary/Nonmonetary Translation Method
(won in millions, dollars in thousands)
Freedom-Korea
Balance Sheet as of September 30, 20x2

Assets
Won
Exchange Rate
Dollars
Cash...................................................................................................................................................................................
W591
$0.00124
$ 732.8
Receivables........................................................................................................................................................................
1,182
0.00124
1,465.7
Inventories..........................................................................................................................................................................
552
0.00126
695.5
Fixed assets........................................................................................................................................................................
575
0.00140
805.0
W2,900
$3,699.0
Liabilities and Owners Equity
Current liabilities................................................................................................................................................................
W624
0.00124
$ 773.8
Capital stock.......................................................................................................................................................................
1,000
0.00140
1,400.0
Retained 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
$9,358.8
Cost of sales.......................................................................................................................................................................
4,415
0.00132*
5,827.8*
Other expenses (excl. deprec.)............................................................................................................................................
1,374
0.00132
1,813.7
Depreciation.......................................................................................................................................................................
25
0.00140
35.0
Operating income...............................................................................................................................................................
1,276
1,682.3
Translation 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
$
0.0
Plus purchases....................................................................................................................................................................
4,967
0.00132
6,556.4
Less ending inventory........................................................................................................................................................
(552)
0.00126
(695.5)
Cost of sales.......................................................................................................................................................................
W4,415
$5,860.9

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Chapter 10 - Other Items That Affect Net Income and Owners Equity

Case 10-4: Proxim Inc.*


Note: This case is unchanged from the Twelfth Edition..
Approach
Accounting earnings have long been the key summary measure of corporate performance. Investors have
focused on earnings computed in accordance with generally accepted accounting principlesGAAP-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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Chapter 10 - Other Items That Affect Net Income and Owners Equity

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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Chapter 10 - Other Items That Affect Net Income and Owners Equity

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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Chapter 10 - Other Items That Affect Net Income and Owners Equity

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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Chapter 10 - Other Items That Affect Net Income and Owners Equity

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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Chapter 10 - Other Items That Affect Net Income and Owners Equity

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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Chapter 10 - Other Items That Affect Net Income and Owners Equity

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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Chapter 10 - Other Items That Affect Net Income and Owners Equity

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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Chapter 10 - Other Items That Affect Net Income and Owners Equity

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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