Chapter 4 - Income Statement and Related Information

Question 1

What are the limitations of the Income Statement? (3)

Answer 1

1. Companies omit items from the Income Statement that cannot be measured reliably.
   Ex. unrealized gain or loss on investment securities
   Ex. the value of brand recognition, customer service, and product quality
2. Income numbers are affected by the accounting methods employed.
   Ex. One company may use an accelerated depreciation method for plant assets
   while another may use straight line, making it difficult to compare
3. Income measurement involves judgement
   Ex. One company may estimate the useful life of an asset to be 20 years, while another company uses a 15 year estimate for the same type of asset
   Ex. Some companies may make optimistic estimates of future warranty costs and bad debt write-offs which results in lower expenses and higher income.

Question 2

What is earnings management?

Answer 2

Earnings management negatively affects the quality of earnings by distorting financial information in a way that is less useful for predicting future earnings and cash flows. It is often defined as the planned timing of revenues, expenses, gains, or losses to smooth out bumps in earnings.

Ex. Prematurely recognize sales in order to boost earnings.

Ex. “Cookie jar” reserves. Companies establish reserves by using unrealistic assumptions to estimate liabilities for such items as loan losses, restructuring charges, and warranty returns. The companies then reduce these reserves in the future when needing to increase reported income.

Question 3

The reporting of a discontinued operation involves a strategic shift that is substantial in nature. What would be considered substantial? (3)

Answer 3

1. The sale of a product line that represents 15% of a company’s total revenues.
2. The sale of a geographical area that represents 20% of a company’s total assets.
3. The sale of a component that is an equity investment that represents 20% of a company’s total assets.