Case 5-1 Income Smoothing

One reason accounting earnings might not be a realistic measure of economic income is the incentive and ability of business
managers to manipulate reported profits for their own benefit. This may be particularly true when their company has an incentive
compensation plan linked to reported net income. The manipulation of earnings, known as earnings management, commonly
involves income smoothing. Income smoothing has been identified as the dampening of fluctuations about some level of earnings
that is considered normal for the company. Research has indicated that some level of income smoothing occurs because business
managers prefer a stable rather than a volatile earnings trend.

Required:

a. Why do business managers prefer stable earnings trends?

a. “Earnings management is the use of accounting techniques to produce financial reports that present an overly positive
view of a company’s business activities and financial position. Many accounting rules and principles require company
management to make judgments. Earnings management takes advantage of how accounting rules are applied and
creates financial statements that inflate earnings, revenue or total assets.” (Investopedia.com, 2016) As indicated in
the text, Financial Accounting Theory and Analysis: Text and Cases, business managers may feel the need to manage
earnings in an effort to stabilize earnings trends due to the fact that this information might influence the choices made
by both potential investors and creditors. In addition, “earnings management techniques are designed to improve
reported income effects and to lower the company’s cost of capital. On the other hand, in a move to increase future
profits, management might take the opportunity to report more bad news in periods when performance is low.”
(Schroeder, Clark, and Cathey, 2014)
b. There are several methods that business managers might use to smooth earnings. These include taking a bath, creative
acquisition accounting, “cookie jar” reserves, abusing the materiality concept, and improper revenue recognition
methods. These techniques are outlined in the below table.

Taking a bath The one-time overstatement of restructuring charges to reduce assets, which reduce
future expenses. The expectation is that the one-time loss is discounted in the
marketplace by analysts and investors, who will focus on future earnings.
Creative acquisition Avoiding future expenses by one-time charges for in-process research and
accounting development.
“Cookie jar” reserves Overstating sales returns or warranty costs in good times and using these
overstatements in bad times to reduce similar charges.
Abusing the materiality Deliberating recording errors or ignoring mistakes in the financial statements under
concept the assumption that their impact is not significant.
Improper revenue Recording revenue before it is earned.
recognition
(Schroeder, Clark, and Cathey, 2014)
Case 5-2 Earnings Quality

Economic income is considered to be a better predictor of future cash flows than accounting income is. A technique used by
security analysts to determine the degree of correlation between a firm’s accounting earnings and its true economic income is
quality of earnings assessment.

Required:

a. Discuss measures that may be used to assess the quality of a firm’s reported earnings.
b. Obtain an annual report for a large corporation and perform a quality of earnings assessment.

a. Accounting earnings are defined as, “the amount of money a company has earned during a given period, usually a
quarter or a year, as reported based on proper accounting standards.” (Investopedia.com, 2016) Economic earnings
are defined as the, “amount of money a business expects to earn assuming there are no changes in its ability or
capacity to produce its products or services.” (BusinessDictionary.com, 2017) Earnings quality essentially encompasses
the extent to which accounting earnings and economic earnings are connected or interrelated. The following table
illustrates eight methods that can be used to ascertain the quality of an organization’s earnings.

1. Compare the accounting principles employed by a company with those generally used in the industry and
by the competition. Do the principles used by the company inflate earnings?
2. Review recent changes in accounting principles and changes in estimates to determine if they inflate
earnings.
3. Determine whether discretionary expenditures, such as advertising, have been postponed by comparing
them to those of previous periods.
4. Attempt to assess whether some expenses, such as warranty expense, are not reflected on the income
statement.
5. Determine the replacement cost of inventories and other assets. Assess whether the company generates
sufficient cash flow to replace its assets.
6. Review the notes to financial statements to determine whether loss contingencies exist that might reduce
future earnings and cash flows.
7. Review the relationship between sales and receivables to determine whether receivables are increasing
more rapidly than sales.
8. Review the management discussion and analysis section of the annual report and the auditor’s opinion to
determine management’s opinion of the company’s future and to identify any major accounting issues.
(Schroeder, Clark, and Cathey, 2014)
b. After reviewing Amazon’s 2016 Annual Report; the following conclusions could be drawn with respect to their earnings
quality.
1. The first method discussed previously to validate an organization’s earnings quality is to review its’ financial
statements and disclosures to ascertain whether or not the accounting principles employed by the company was
in line with those accounting principles employed by similar organizations in the same industry. It appeared that
Amazon’s accounting principles were similar to those operating in similar industries. The following excerpts
document the revenue recognition policies of both Amazon and Walmart as detailed on their 2016/2017 Annual
Reports. They seem very similar in content. The other accounting policies outlined in the Amazon 2016 Annual
Report showed similar comparability to others operating in the same industry.

We recognize revenue from product sales or services rendered when the following four criteria are
met: persuasive evidence of an arrangement exists, delivery has occurred or service has been
rendered, the selling price is fixed or determinable, and collectability is reasonably assured. Revenue
arrangements with multiple deliverables are divided into separate units and revenue is allocated
using estimated selling prices if we do not have vendor-specific objective evidence or third-party
evidence of the selling prices of the deliverables. We allocate the arrangement price to each of the
elements based on the relative selling prices of each element. Estimated selling prices are
management’s best estimates of the prices that we would charge our customers if we were to sell
 the standalone elements separately and include considerations of customer demand, prices charged
by us and others for similar deliverables, and the price if largely based on the cost of producing the
product or service. Sales of our digital devices, including Kindle e-readers, Fire tablets, Fire TVs, and
Echo, are considered arrangements with multiple deliverables, consisting of the device, undelivered
software upgrades and/or undelivered non-software services such as cloud services and free trial
memberships to other services. The revenue allocated to the device, which is the substantial portion
of the total sale price, and related costs are generally recognized upon delivery. Revenue related to
undelivered software upgrades and/or undelivered non-software services is deferred and recognized
generally on a straight-line basis over the estimated period the software upgrades and non-software
services are expected to be provided for each of these devices.
Sales of Amazon Prime memberships are also considered arrangements with multiple deliverables,
including shipping benefits, Prime Video, Prime Music, Prime Photos, and access to the Kindle
Owners’ Lending Library. The revenue related to the deliverables is amortized over the life of the
membership based on the estimated delivery of services. Amazon Prime membership fees are
allocated between product sales and service sales. Costs to deliver Amazon Prime benefits are
recognized as cost of sales as incurred. As we add more benefits to the Prime membership, we will
update the method of determining the estimated selling prices of each element as well as the
allocation of Prime membership fees. (Amazon.com, 2016)
The Company recognizes sales revenue, net of sales taxes and estimated sales returns, at the time it
sells merchandise to the customer. Digital retail sales include shipping revenue and are recorded
upon delivery to the customer. The Company recognizes membership fee revenue both in the U.S.
and internationally over the term of the membership, which is typically 12 months. (Walmart.com,
2017)

2. The second technique for determining the quality of earnings is to determine if the organization made any recent
changes in their accounting policies or changes in accounting estimates. After reviewing Amazon’s 2016 Annual
Report it did not appear there were any significant changes in accounting policies or accounting estimates that
would artificially inflate earnings.
3. Third, in determining whether discretionary expenditures such as advertising expenses had been postponed as
compared to prior periods proved to be false upon review of Amazon’s 2016 Annual Report. This can be
concluded due to the fact that their marketing expenses have actually increased during the last three years. “The
increase in marketing costs in absolute dollars in 2014, 2015, and 2016, compared to the comparable prior year
periods, is primarily due to increased spending on online marketing channels and television advertising, as well as
payroll and related expenses.” (Amazon.com, 2016)
4. The fourth technique to determine the quality of earnings includes assessing whether some expenses are not
included in the P&L statement. Expenses such as warranty expenses are included in this category. After reviewing
Amazon’s 2016 Annual Report it did not appear that there was any information regarding warranty expense.
Therefore, applying this earnings quality assessment method was unsuccessful.
5. The fifth earnings quality assessment method determined the replacement cost of inventories and other assets. It
also involved determining whether or not the organization would produce adequate cash flow to replenish these
assets. It appears that Amazon does generate sufficient cash flows to replace its assets such as inventories.
6. The sixth earnings quality assessment technique involves reviewing the notes to the financials that might
document loss contingencies that might adversely impact future cash flows. Upon review of the 2016 Amazon
Annual Report documented tax contingencies which might impact future earnings opportunities and cash flows.
However, the financials also indicated that it had 1.7B accrued to cover these tax contingencies. The following
section documents Amazon’s disclosure of their tax contingencies in their 2016 Annual Report.

We are subject to income taxes in the U.S. (federal and state) and numerous foreign jurisdictions.
Significant judgment is required in evaluating our tax positions and determining our provision for
income taxes. During the ordinary course of business, there are many transactions and calculations
for which the ultimate tax determination is uncertain. We establish reserves for tax-related
uncertainties based on estimates of whether, and the extent to which, additional taxes will be due.
These reserves are established when we believe that certain positions might be challenged despite
our belief that our tax return positions are fully supportable. We adjust these reserves in light of
changing facts and circumstances, such as the outcome of tax audits. The provision for income taxes
includes the impact of reserve provisions and changes to reserves that are considered appropriate.
 As of December 31, 2015 and 2016, we had accrued interest and penalties, net of federal income tax
benefit, related to tax contingencies of $59 million and $67 million. Interest and penalties, net of
federal income tax benefit, recognized for the years ended December 31, 2014, 2015, and 2016 was
$8 million, $18 million, and $9 million. We are under examination, or may be subject to
examination, by the Internal Revenue Service (“IRS”) for the calendar year 2005 and thereafter.
These examinations may lead to ordinary course adjustments or proposed adjustments to our taxes
or our net operating losses with respect to years under examination as well as subsequent periods.
As previously disclosed, we have received Notices of Proposed Adjustment from the IRS for
transactions undertaken in the 2005 and 2006 calendar years relating to transfer pricing with our
foreign subsidiaries. The IRS is seeking to increase our U.S. taxable income by an amount that would
result in additional federal tax of approximately $1.5 billion, subject to interest. To date, we have not
resolved this matter administratively and are currently contesting it in U.S. Tax Court. We continue
to disagree with these IRS positions and intend to defend ourselves vigorously in this matter. In
addition to the risk of additional tax for 2005 and 2006 transactions, if this litigation is adversely
determined or if the IRS were to seek transfer pricing adjustments of a similar nature for
transactions in subsequent years, we could be subject to significant additional tax liabilities.
(Amazon.com, 2016)

7. The seventh earnings quality measurement technique encompasses the evaluation an organization’s relationship
between its sales and accounts receivable and to assess whether or not the receivables are increasing more
quickly than its sales. It did not appear that Amazon’s receivables were increasing more than its sales.
8. The eighth earnings quality measure method involves reviewing the Management Discussion and Analysis section
of the Annual Report as well as the auditor’s opinion in an effort to determine how management feels about the
organization as well as any dilemmas documented by the auditors. After reviewing Amazon’s 2016 Annual Report
it appeared that Ernst and Young determined that Amazon prepared their financial statements in accordance with
GAAP. In addition, the Management Discussion and Analysis section indicated that they had high hopes for the
organization as a whole and seemed confident in the path that they were currently all.

By utilizing the eight earnings quality techniques to review Amazon’s Annual Report it appears that Amazon does seem
to have quality earnings.
Case 5-4 Cost, Expense, and Loss

You are requested to deliver your auditor’s report personally to the board of directors of Sebal Manufacturing Corporation and
answer the questions posed about the financial statements. While reading the statements, one director asks, “What are the
precise meanings of the terms cost, expense, and loss? These terms sometimes seem to identify similar items and other times
seem to identify dissimilar items.”

Required:

a. Explain the meanings of (1) cost, (2) expense, and (3) loss as used for financial reporting in conformity with GAAP. In your
explanation, discuss the distinguishing characteristics of the terms and their similarities and interrelationships.
b. Classify each of the following items as a cost, expense, or loss, or other category, and explain how the classification of
each item may change:
i. Cost of goods sold
ii. Bad debts expense
iii. Depreciation expense for plant machinery
iv. Organization costs
v. Spoiled goods
c. The terms period cost and product cost are sometimes used to describe certain items in financial statements. Define
these terms and distinguish them. To what types of items does each apply?

a. The definitions for cost, expense, and loss are outlined in the below table:

Cost The amount given in consideration of goods received or to be received. Costs can be categorized as
unexpired (assets), which are associated with the production of future revenues, and expired; those not
associated with the production of future revenues, and expired; those not associated with the production of
future revenues and thus deducted from revenues or retained earnings in the current period.
Expense Outflows of assets or incurrences of liabilities (or a combination of both) during a period from delivering or
producing goods, rendering services, or carrying out other activities that constitute an entity’s ongoing major
operations.
Loss Decreases in assets from peripheral or incidental transaction of an entity and from all other transactions and
events that affect the entity during a period except those that result from expenses or distributions to
owners.
(Schroeder, Clark, and Cathey, 2014)

According to the text, Financial Accounting Theory and Analysis: Text and Cases, “expenses are revenue-producing cost
expirations, whereas losses are non-revenue-producing cost expirations.” (Schroeder, Clark, and Cathey, 2014) Essentially
the organization must ascertain which costs have been antiquated during the current reporting period. If the cost provides
future benefit by being consumed during the revenue generating process it is then expensed. If it is consumed and it is not
done so during the revenue generating process it would then be considered a loss.

b.

i. Cost of goods sold are costs until they are consumed during the production of an entity’s product
(presumably given that this is COGS) at which time they would be expensed.
ii. Bad debt expense is an expense an entity incurs during a given period when it is unable to obtain
payment for the goods or services. However, it would then be deemed a loss due to the fact that it
would be then categorized as expired.
iii. Depreciation expense for plant machinery is an expense because it is consumed during the revenue
generating process during the current period.
 iv. Organization costs are costs until they are consumed during a future period at which point they
would be expensed.
v. Spoiled goods would be classified as other items. However, they might be categorized as a loss
during the current period due to the fact that they expired.
c. The terms product cost and period cost are defined in the following table:

Product Cost Cost expirations that can be directly associated with the company’s product, such as direct
material, direct labor, and direct factory overhead.
Period Cost Cost expirations that are more closely related to a period of time than to a product, such as
administrative salaries or advertising costs. Period costs get charged to expense on the basis of
the period of benefit.

Basically product costs are direct costs and period costs are indirect costs associated with a specific period of time.
Case 5-6 Presentation of Financial Statement Information

The FASB has issued SFAC No. 5, “Recognition and Measurement in Financial Statement of Business Enterprises.” In general, this
statement sets recognition criteria and guidance for what information should be incorporated into financial statements and when
this information should be reported.

Required:

According to SFAC No. 5, five general categories of information should be provided by a full set of financial statements. List and
discuss these five categories of information.

There are 5 general categories that should be included in a full set of financial statements. These categories include the financial
position at the end of the period, net income for the current period, comprehensive income for the period, cash flows resulting
from the current period, and investments from and distributions to owners during the current period. Financial statements
musts encompass these categories in order to provide financial statement users with a complete picture regarding the overall
health of the organization. In order to achieve this goal; they must endeavor to summarize and evaluate the financial activities
that occurred during the current accounting period. Thus, the financial position at the end of the period is the end point of all
the activity for the current period. The financial statements must also list the net income from the current period which is detail
on the income statement and considers all revenues and expenses generated during the current period. The comprehensive
income for the period is reflected on the comprehensive income statement which is more detailed than the original income
statement. It details additional information such as gains and losses which can paint a more comprehensive picture of the
organization. Cash flows from the current period are shown on the statement of cash flows. Finally, the investments from and
distributions to owners are outlined on the statement of retained earnings.
Accounting Earnings. (2015, September 28). Retrieved October 07, 2017, from
http://www.investopedia.com/terms/a/accountingearnings.asp

Amazon 2016 Annual Report. (n.d.). Retrieved October 07, 2017, from http://phx.corporate-
ir.net/phoenix.zhtml?c=97664&p=irol-reportsannual

Earnings Management. (2016, June 05). Retrieved October 07, 2017, from http://www.investopedia.com/terms/e/earnings-
management.asp

Economic Earnings. BusinessDictionary.com. Retrieved October 07, 2017, from BusinessDictionary.com website:
http://www.businessdictionary.com/definition/economic-earnings.html

Schroeder, R. G., Clark, M. W., & Cathey, J. M. (2014). Financial Accounting Theory and Analysis: Text and Cases. Hoboken: John
Wiley & Sons.

Walmart 2017 Annual Report. (n.d.). Retrieved October 07, 2017, from http://stock.walmart.com/investors/financial-
information/annual-reports-and-proxies/default.aspx