Term Paper: Consolidation of Financial Statement Analysis

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[. . .] In the asset section of the balance sheet, assets are listed in the "order of liquidity" (where liquidity is defined as the ability to convert an economic resource into cash with minimal risk of loss). It is a common practice to report financial position through the use of a classified balance sheet. In the classified balance sheet, assets are then classified as being current (if the economic resource is expected to be used or consumed in operations or converted into cash within one year from the balance sheet or one operating cycle, whichever is longer). In this regard, the operating cycle is considered to be the "cash-to-cash" cycle of the firm. For some types of applications, such as those needing an aging process, a single operating cycle may extend beyond one year; however, generally speaking, assets that meet the one-year criterion are classified as current. By contrast, if the asset is expected to provide economic benefit for a period longer than one year from the balance sheet date, it would be classified as a long-term or noncurrent asset (Sannella, 1991).

According to Sannella, liabilities are required to be listed in the "order of maturity." It is still a common reporting practice to classify liabilities as current if due within one year of the balance sheet date, and noncurrent or long-term if payable in a period greater than one year from the balance sheet date. Sannella notes that, in theory at least, a current liability is properly defined as an obligation whose liquidation will require the use of economic resources properly classified as current assets or the creation of other current liabilities. While the latter definition captures the operating cycle concept used in the discussion of current and noncurrent assets, the one-year criterion for the classification of liabilities is generally sufficient in practice (Sannella, 1991).

The classification of assets and liabilities provides some useful information for the analyst in "matching maturities" of assets and liabilities. In this case, the excess of current assets over current liabilities, or working capital, is an important component for a timely assessment of a company's liquidity in the analysis of financial statements.

Finally, capital is classified as stockholders' equity on the corporate balance sheet. The stockholders' equity section of the balance sheet consists of two major components: contributed or paid-in capital and retained earnings (Sannella, 1991).

The contributed or paid-in capital component includes the capital stock (either common or preferred) issued by the entity at par or face value, and the amounts received above par value. The amounts received over par value are known as additional paid-in capital or paid-in capital in excess of par. The retained earnings represent the historical record of earnings or losses that have not been paid out or distributed as dividends (Sannella, 1991).

The income statement is a listing of revenues, expenses, and net income or net loss over a period of time. The income statement presents the change in owners' wealth or the flow of wealth for the accounting period (e.g., one month, one quarter or one year). Finally, the model for the income statement is simply Net Income (Loss) = Revenues - Expenses (Sannella, 1991).

Because the balance sheet represents the stock of wealth at a point in time, it is a cumulative statement. By contrast, the income statement reflects the flow of wealth or the change in capital resulting from the operations of the firm over a particular period of time. As a result, the balance sheet is a permanent statement while the income statement is only a temporary statement. Consequently, at the end of each accounting period, the change in owners' wealth from the income statement must be transferred to capital (specifically retained earnings) on the balance sheet (Sannella, 1991).

Further complicating matters is the provision in the existing accounting rules that provides companies that decide to expense options their choice of three ways to calculate the cost:

The first approach, used by companies including Coca-Cola and Bank One Corp., the expense accrues gradually with new option awards.

The second method would be to include options granted in previous years, as well as current grants, creating an even greater hit to earnings.

The third method requires companies to include old awards and restate their earnings from previous years as if they had been expensing options in the past (Robinson, 2002).

Sufficiency of "Patching Up" Initiatives. According to Louis Lowenstein (2002), financial accounting has but one straightforward goal: "To give investors and other outsiders an honest report on a company's performance and management's stewardship. Accurate accounting ("transparency") is something that Americans preach to other nations as an essential precondition for successful capitalism" (Lowenstein, 2002, p. 19). In this regard, the Financial Accounting Standards Board (FASB) has long recognized the need to refine its guidance concerning which entities should be included in consolidated financial statements. In 1994, after more than a decade since it first began studying the issue (which was included in a 1982 FASB project undertaken in response to questions about consolidation policy from the American Institute of CPAs, the Securities and Exchange Commission and others), the board published its "Preliminary Views on Major Issues Related to Consolidation Policy" and requested comments from the public (FASB Presents Views on Consolidated Statements, 1994).

The issue of what factors represent actual control of another entity have been problematic for a number of years. The FASB document, as well as the final statement the board eventually issued, represented a change from the board's past position and will provide needed guidance. "I think this is a significant step in an area where there have been a lot of questions," said Ernest F. Baugh, Jr., a partner of Joseph Decosimo and Co., Chattanooga, Tennessee, and a member of the Institute's accounting standards executive committee. "Prior to this, FASB's position was that you prepared a consolidated financial statement when you owned over 50% of another company. But there were many cases when things were not clear-cut" (FASB Presents Views on Consolidated Statements 1994, p. 23). In fact, control of a company could be established with less stock than that; for instance, the FASB uses the examples of two companies that could each own 49% of a subsidiary, and an individual could own the other 2%. If one of the entities actually controlled that individual, it would in reality control the subsidiary as well; however, this fact would not be reflected on the financial statements. Likewise, a firm could place some of its fixed assets and all of its debt related to that into a subsidiary and not have that appear on its balance sheet. "Thus, creditors or customers would not see the whole picture" (FASB Presents Views on Consolidated Statements 1994, p. 23).

The FASB proposal addressed this problem by defining control of an entity as "power over its assets" -- power to use or direct the use of the individual assets of the subsidiary to achieve the parent's objectives. Unless its control was temporary, a parent company would have to consolidate all its subsidiaries when an entity became a subsidiary (FASB Presents Views on Consolidated Statements 1994). Furthermore, these consolidation rules also extended to include not-for-profit organizations, trusts and partnerships as well as business corporations, toward which then-current standards for consolidation policy were primarily directed.

Governmental entities are also affected the consolidated financial statement requirements. In 2002, the top auditor for the U.S. government reported that the agencies and departments of the federal government were unable to properly account for the money each was entrusted with and, therefore, he was unable to produce a legitimate consolidated financial statement (O'Meara 2002).

In addition, while the Financial Accounting Standards Board has favored expensing stock options since the mid-1990s, it has continued to allow businesses to recognize the expense in footnotes to financial statements as an alternate reporting method. Recent publicity concerning accounting fraud, executive excesses, "cooking the books," and other questionable business practices has brought stock option plans to center stage attention in the United States as investors as seeking more informed methods of assessing the financial health of an enterprise. Legislative reforms mandating greater amounts of disclosure bring along a myriad of administrative challenges. Complicating matters is the complex methods by which the value of these options have been historically calculated. Faced with this changing landscape, many companies are being forced into difficult decisions around broad-based equity compensation (Pike & Neale, 1996). During the past decade, American corporations have granted more and more stock options as compensation, especially for top executives. An option gives the holder the right to buy or sell stock at a specified price by a specific date. If the right to buy shares is set at a low price and the stock goes up, the option holder makes a profit. Critics of the proposed changes argue that options provide vital incentives for skilled employees and executives, especially those who work for risky high-tech ventures. Advocates of reform maintain that options give executives… [END OF PREVIEW]

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