In this article we will discuss about:- 1. Introduction to Interim Reporting 2. Minimum Disclosures in Interim Reports 3. Segment Information in Interim Reports.
Introduction to Interim Reporting:
To give investors and creditors more timely information than an annual report provides, companies show financial information for periods of less than one year. The SEC requires publicly traded companies in the United States to provide financial statements on a quarterly basis. Unlike annual financial statements, financial statements included in quarterly reports filed with the SEC need not be audited. This allows companies to disseminate the information to investors and creditors as quickly as possible.
APB Opinion No. 28 issued in 1973 provides guidance to companies as to how to prepare interim statements. That opinion has stood the test of time with only two subsequent authoritative pronouncements related to interim reporting. The FASB’s SFAS 3 amended APB Opinion No. 28 with regard to reporting accounting changes in interim statements, and FASB Interpretation No. 18 clarifies the application of APB Opinion No. 28 with regard to income taxes.
ADVERTISEMENTS:
Some inherent problems are associated with determining the results of operations for time periods of less than one year, especially with regard to expenses that do not occur evenly throughout the year.
Two approaches can be followed in preparing interim reports:
(1) Treat the interim period as a discrete accounting period, standing on its own, or
(2) Treat it as an integral portion of a longer period.
ADVERTISEMENTS:
Considering the annual bonus a company pays to key employees in December of each year illustrates the distinction between these two approaches. Under the discrete period approach, the company reports the entire bonus as an expense in December, reducing fourth quarter income only. Under the integral part of an annual period approach, a company accrues a portion of the bonus to be paid in December as an expense in each of the first three quarters of the year.
Obviously, application of the integral approach requires estimating the annual bonus early in the year and developing a method for allocating the bonus to the four quarters of the year. The advantage of this approach is that there is less volatility in quarterly earnings as irregularly occurring costs are spread over the entire year.
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. Generally speaking, companies should prepare interim financial statements following the same accounting principles and practices they use in preparing annual statements.
However, deviation from this general rule is necessary for several items so that the interim statements better reflect the expected annual amounts.
ADVERTISEMENTS:
Special rules related to revenues, inventory and cost of goods sold, other costs and expenses, extraordinary items, income taxes, accounting changes, and seasonal items are as follows:
Companies should recognize revenues in interim periods in the same way they recognize revenues on an annual basis. For example, a company that accounts for revenue from long-term construction projects under the percentage of completion method for annual purposes should also recognize revenue in interim statements on a percentage of completion basis. Moreover, a company should recognize projected losses on long-term contracts to their full extent in the interim period in which it becomes apparent that a loss will arise.
II. Inventory and Cost of Goods Sold:
ADVERTISEMENTS:
Interim period accounting for inventory and cost of goods sold requires several modifications to procedures used on an annual basis. The modifications relate to- (1) a LIFO liquidation, (2) application of the lower-of-cost-or-market rule, and (3) standard costing.
1. LIFO Liquidation:
Companies using the last-in, first-out (LIFO) cost-flow assumption to value inventory experience a LIFO liquidation at the end of an interim period when the number of units of inventory sold exceeds the number of units added to inventory during the period. When prices are rising, matching beginning inventory cost (carried at low LIFO amounts) against the current period sales revenue results in an unusually high amount of gross profit.
If, by year-end, the company expects to replace the units of beginning inventory sold, there is no LIFO liquidation on an annual basis. In that case, gross profit for the interim period should not reflect the temporary LIFO liquidation, and inventory reported on the interim balance sheet should include the expected cost to replace the beginning inventory sold.
ADVERTISEMENTS:
To illustrate, assume that Liquid Products Company began the first quarter with 100 units of inventory that cost $10 per unit. During the first quarter, it purchased 200 units at a cost of $15 per unit, and sold 240 units at $20 per unit. During the first quarter, the company experienced a liquidation of 40 units of beginning inventory.
It calculates gross profit as follows:
2. Lower of Cost or Market Rule:
ADVERTISEMENTS:
If at the end of an interim period, the fair value of inventory is less than its cost, the company should write down inventory and recognize a loss so long as it deems the fair value decline to be permanent. However, if it expects the fair value to recover above the inventory’s original cost by year end, it should not write down inventory at the interim balance sheet date. Instead, it should continue to carry inventory at cost.
3. Standard Costing:
A company should not reflect in interim financial statements planned price, volume, or capacity variances arising from the use of a standard cost system that are expected to be absorbed by the end of the annual period. However, it should report unplanned variances at the end of the interim period in the same fashion as it would in the annual financial statements.
III. Other Costs and Expenses:
ADVERTISEMENTS:
A company should charge costs and expenses not directly matched with revenues to income in the interim period in which they occur unless they can be identified with activities or benefits of other interim periods. In that case, the cost should be allocated among interim periods on a reasonable basis through the use of accruals and deferrals. For example, assume that a company required to prepare quarterly financial statements pays annual property taxes of $100,000 on April 10. One-fourth of the estimated property tax should be accrued as expense in the first quarter of the year.
When it makes the payment, it should apply one-fourth against the accrued property tax payable from the previous quarter and charge one-fourth to second-quarter income. The company should defer one-half of the payment as a prepaid expense to be allocated to the third and fourth quarters of the year. The following journal entries demonstrate the procedures for ensuring that the company recognizes one-fourth of the annual payment as expense in each quarter of the year.
Other items requiring similar treatment include annual major repairs and advertising. In addition, a number of adjustments such as bad debt expense, executive bonuses, and quantity discounts based on annual sales volume that are normally made at year-end actually relate to the entire year. To the extent that the company can estimate annual amounts, it should make adjustments at the end of each interim period so that the interim periods bear a reasonable portion of the expected annual amount.
ADVERTISEMENTS:
Companies should report extraordinary gains and losses separately and in full in the interim period in which they occur. Companies should deem gains and losses extraordinary if they are- (1) unusual in nature, (2) infrequent in occurrence, and (3) material in amount. The materiality of extraordinary items should be determined by comparing the amount of the gain or loss to the expected income for the full year. Companies should separately disclose unusual and infrequent gains and losses material to the interim period but not to the year as a whole. Likewise, they should separately disclose gains and losses on the disposal of a business segment in the interim period in which the disposal occurs.
For example, assume that Charleston Company incurred a hurricane loss of $100,000 in the first quarter that it deems to be both unusual and infrequent. First-quarter income before subtracting the hurricane loss is $800,000, and annual income is expected to be $10 million. The loss is clearly material with respect to first-quarter income (12.5 percent) but is not material for the year as a whole (1 percent). Charleston should not label this loss an extraordinary item on its first-quarter income statement but nevertheless should separately disclose the loss (either as a separate line item on the income statement or in the notes).
Companies should disclose contingencies in interim reports the same way they disclose them in annual reports. The contingency should continue to be reported in subsequent interim and annual reports until it is resolved or becomes immaterial. Materiality should be judged with respect to the year as a whole.
Companies should compute income tax related to ordinary income at an estimated annual effective tax rate. At the end of each interim period, a company makes its best estimate of the effective tax rate for the entire year. The effective tax rate reflects anticipated tax credits, foreign tax rates, and tax planning activities for the year. It then applies this rate to the pretax ordinary income earned to date during the year, resulting in the cumulative income tax expense to recognize to date.
The difference between the cumulative income tax recognized to date and income tax recognized in earlier interim periods is the amount of income tax expense recognized in the current interim period.
Assume that Viertel Company estimated its effective annual tax rate at 42 percent in the first quarter of 2009. Pretax income for the first quarter was $500,000. At the end of the second quarter of 2009, the company expects its effective annual tax rate will be only 40 percent because of the planned usage of foreign tax credits. Pretax income in the second quarter of 2009 is also $500,000. No items require net-of-tax presentation in either quarter.
The income tax expense recognized in each of the first two quarters of 2008 is determined as follows:
The same process is followed for the third and fourth quarters of the year.
Companies should compute income tax related to those special items reported net of tax (extraordinary items and discontinued operations) and recognize them when the item occurs. FASB Interpretation No. 18 explains that the income tax on an interim period special item is calculated at the margin as the difference between income tax on income including this item and income tax on income excluding this item.
VI. Change in Accounting Principle:
Until 2005, APB Opinion No. 20, “Accounting Changes,” and FASB SFAS 3, “Reporting Accounting Changes in Interim Financial Statements,” governed the treatment of the effect of a change in accounting principle in interim reports. Generally, under APBO 20, a change in accounting principle required a company to recalculate previous years’ income based on the new accounting principle and include the cumulative effect in income in the year of change.
When a cumulative effect type of accounting change occurred in the first interim period, SFAS 3 required including the entire cumulative effect in income of the first interim period. If an accounting change was made in other than the first interim period no cumulative effect was included in income for that period. Instead, income for the first interim period of the year was restated to include the cumulative effect of the accounting change.
FASB SFAS No. 154, “Accounting Changes and Error Corrections,” issued in May 2005, replaces both APBO 20 and SFAS 3 and amends the accounting for a change in accounting principle. SFAS 154 requires retrospective application of the new accounting principle to prior periods’ financial statements. Retrospective application means that comparative financial statements will be restated as if the new accounting principle had always been used. Whether an accounting change occurs in the first or in a subsequent interim period has no bearing on the manner in which the change is reflected in the interim financial statements.
According to SFAS 154, changes in accounting principle, regardless of when the accounting change is made, are handled as follows:
a. The cumulative effect of the change to the new accounting principle on periods prior to those presented shall be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented.
b. An offsetting adjustment, if any, shall be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period.
c. Financial statements for each individual prior period shall be adjusted to reflect the period- specific effects of applying the new accounting principle.
When the accounting change takes place in other than the first interim period, SFAS 154 requires information for the interim periods prior to the change to be reported by retrospectively applying the new accounting principle to those pre-change interim periods. If retrospective application is impracticable, the accounting change is not allowed to be made in an interim period but may be made at the beginning of the next fiscal year.
The FASB expects that situations in which the retrospective application of a new accounting principle to pre-change interim periods is not feasible will be rare.
Illustration of Accounting Change Made in other than First Interim Period:
Modal Company began operations on January 1, 2008. The company’s interim income statements as originally reported under the LIFO inventory valuation method follow:
Sales for the second quarter of 2009 are $2,400, cost of goods sold under the FIFO method is $1,000, and operating expenses are $600. Income before income taxes in the second quarter of 2009 is $800, income taxes are $320, and net income is $480.
To prepare interim statements for the second quarter of 2009 in accordance with SFAS 154, net income as originally reported in the first and second quarters of 2008, as well as in the first quarter of 2009, is restated to reflect the change to FIFO.
The manner in which the accounting change is reflected in the second quarter of 2009, with year-to-date information, and comparative information for similar periods in 2008 follows:
The sales volume of some companies experiences significant seasonal variation. Summer sports equipment manufacturers, for example, are likely to have a significant upward spike in sales during the second quarter of the year. To avoid the risk that investors and creditors will be misled into believing that second-quarter earnings indicate earnings for the entire year, APB Opinion No. 28 requires companies to disclose the seasonal nature of their business operations.
In addition, such companies should supplement their interim reports with reports on the 12-month period ended at the interim date for both the current and preceding years.
Minimum Disclosures in Interim Reports:
Many companies provide summary financial statements and notes in their interim reports that contain less information than is included in the annual financial statements.
APB Opinion No. 28 requires companies to provide the following minimum information in their interim reports:
i. Sales or gross revenues, provision for income taxes, extraordinary items, and net income.
ii. Earnings per share.
iii. Seasonal revenues and expenses.
iv. Significant changes in estimates or provisions for income taxes.
v. Disposal of a segment of a business and unusual or infrequently occurring items.
vi. Contingent items.
vii. Changes in accounting principles or estimates.
viii. Significant changes in financial position.
APB Opinion No. 28 also encourages, but does not require, companies to publish balance sheet and cash flow information in interim reports. If they do not include this information, they must disclose significant changes since the last period in cash and cash equivalents, net working capital, long-term liabilities, and stockholders’ equity.
Companies that provide interim reports on a quarterly basis are not required to publish a fourth-quarter report because this coincides with the end of the annual period. When they do not provide separate fourth-quarter financial statements, they should disclose special accounting items occurring in the fourth quarter in the notes to the annual financial statements. These items include extraordinary or unusual and infrequently occurring items, disposals of a segment of the business, and the aggregate effect of year-end adjustments that are material to the results of the fourth quarter.
The SEC requires companies to include selected quarterly financial data in their annual report to shareholders. Southwest Airlines Co. provided quarterly data in its 2005 annual report as shown in Exhibit 8.8.
Segment Information in Interim Reports:
Management’s approach to determining operating segments should result in less costly disclosure because, by definition, management already collects this information. Because the information is readily available, Statement 131 also requires the inclusion of segment disclosures in interim reports. This was one of AIMR’s major recommendations for improving segment reporting.
Statement 131 requires the following information to be included in interim reports for each operating segment:
i. Revenues from external customers.
ii. Intersegment revenues.
iii. Segment profit or loss.
iv. Total assets, if there has been a material change from the last annual report.
In addition, an enterprise must reconcile total segments’ profit or loss to the company’s total income before taxes and disclose any change from the last annual report in the basis for measuring segment profit or loss. Requiring only a few items of information in interim reports is a compromise between users’ desire to have the same information as is provided in annual financial statements and preparers’ cost in reporting the information.
The FASB does not require segment information to be provided in interim financial statements until the second year that a company applies SFAS 131. Without a full set of segment information in an annual report for comparison, the FASB believes that segment information in interim reports would be less meaningful. There is no requirement to provide information about geographic areas or major customers in interim reports.