OBJECTIVES
Derivatives 1
LEARNING 1.
CHAPTER 18
Derivatives, Contingencies, Business Segments, and Interim Reports
Understand the business and accounting concepts connected with derivatives and hedging activities. Uncertainty about the future fair value of assets and liabilities or about future cash flows exposes firms to risk. One way to manage this risk is through the use of derivatives. A derivative is a financial instrument that derives its value from movement of prices, interest rates, or exchange rates associated with an underlying item. Many derivatives are executory contracts, meaning that they are not a transaction but are an exchange of promises about future actions. Identify the different types of risk faced by a business. Of the many types of risk faced by a firm, four important types are: < Price risk. Uncertainty about the future price of an asset. < Credit risk. Uncertainty over whether the party on the other side of a transaction will abide by the terms of the agreement. < Interest rate risk. Uncertainty about future interest rates and their impact on cash flows and the fair value of financial instruments. < Exchange rate risk. Uncertainty about the future U.S. dollar cash flows stemming from assets and liabilities denominated in foreign currencies. Describe the characteristics of the following types of derivatives: swaps, forwards, futures, and options. Swap. Contract in which two parties agree to exchange payments in the future based upon some price or rate. A good example is the exchange of a stream of variable interest payments for a stream of fixed payments. A swap can transform the stream of future cash flows that you have into the cash flow stream that you want.
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2 Forward contract. Agreement between two parties to exchange a specified amount of a commodity, security, or foreign currency at a specified date with the price or rate being set now. Forward contracts are usually settled with cash payments instead of by actual delivery of the underlying asset. Futures contract. Very similar to a forward contract, with the difference being that a futures contract is a standardized instrument that is sponsored by and traded on an organized exchange. Option. Contract giving the owner the right, but not the obligation, to buy or sell an asset at a specified exercise price. A call option gives the owner the right to buy an asset; a put option gives the owner the right to sell an asset. The buyer of an option must pay cash in advance for the option; in exchange, the buyer is protected against unfavorable price or rate movements but can still benefit from favorable movements.
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Define hedging and outline the difference between a fair value hedge and a cash flow hedge. Hedging is the structuring of transactions to reduce risk. Much hedging occurs naturally in business as increases in cost or in the value of liabilities are offset by related increases in revenues or in the value of assets. Derivatives are also used for hedging. The FASB has identified two types of hedges for which derivatives can be used: < Fair value hedge. The change in the fair value of the derivatives offsets changes in fair values of assets or liabilities. < Cash flow hedge. Cash flows from the derivatives offset variability in the cash flows from forecasted transactions.
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3 5. Account for a variety of different derivatives and for hedging relationships. The fair value of all derivatives is to be recognized and reported in the balance sheet. Changes in fair value are reported as follows: < Derivative is not a hedge. Changes in fair value are reported as gains or losses in the income statement. < Derivative is a fair value hedge. Changes in fair value are reported as gains or losses in the income statement and are offset by gains or losses on changes in the fair value of the asset or liability being hedged. < Derivative is a cash flow hedge. Changes in fair value are deferred and reported in comprehensive income (an equity adjustment). These deferred gains and losses are recognized in income on the forecasted date of the cash flows being hedged. Required disclosure includes the cumulative gains or losses included in the reported amounts of hedged assets and liabilities and the cumulative gains or losses deferred as part of comprehensive income.
Contingencies 6. Apply the accounting rules for contingent items to the areas of lawsuits and environmental liabilities. If a contingent liability is probable and can be reasonably estimated, it should be recognized in the financial statements. If a contingent liability is only possible, it should be disclosed in the financial statement notes. Contingent liabilities that are remote should not, in general, be disclosed. In accounting for lawsuits, firms are usually reluctant to disclose specific amounts or to overestimate the likelihood of losing the suit since they don't want to increase their chances of losing the lawsuit or of paying a large judgment amount. Accounting for environmental remediation liabilities is complicated by the fact that the future cost of the cleanup is very difficult to estimate. In addition, each cleanup project is surrounded by suits and countersuits between government agencies and the responsible firms and among the responsible firms themselves. The SEC requires substantial disclosure of the details of a firm's environmental cleanup projects.
Segment Reporting 7. Prepare the necessary supplemental disclosures of financial information by product line and by geographic area.
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4 Historically, segment reporting in the United States has been more extensive than in any other country. Recently, the FASB has worked with the AcSB in Canada and with the IASC to improve segment reporting worldwide. Under the provisions of the FASB's Statement No. 131, companies are required to disclose the following information for each business segment: revenues, operating profit, assets, liabilities, capital expenditures, and certain income statement items such as depreciation and interest revenue and expense. Firms are to define their reportable business segments using the same practice that is used internally. The objective of this requirement is to provide external users with the same type of segment information used inside the company.
Interim Reporting 8. Recognize the importance of interim reports, and outline the difficulties encountered when preparing those reports. In the United States, publicly traded firms are required to file quarterly summary financial statements with the SEC in a filing called a 10-Q. These interim financial statements are prepared using the "integral part of annual period" concept. Using this concept, each quarter is not viewed as a separate period; instead, each quarter is viewed as an integral part of the year, and estimates are used to appropriately allocate a share of the annual results to each quarter. Quarterly reports are typically not audited, but they still are to be prepared in accordance with GAAP.
CHAPTER REVIEW OUTLINE
DERIVATIVES I. SIMPLE EXAMPLE OF A DERIVATIVE (p. 1050). A. Derivative. 1. A financial instrument that derives its value from the movement of the price, foreign exchange rate, or interest rate on some other underlying asset or financial instrument. 2. Most firms use derivatives as a tool for managing risk. 3. A derivative does not require a firm to take delivery or make delivery of the underlying asset or financial instrument. 4. Often settled by a simple exchange of cash. B. Executory Contract.
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5 1. An exchange of promises to engage in a transaction in the future. 2. Example--an operating lease, or a promise to make payments in the future in exchange for the promise to receive the use of an asset in the future. II. TYPES OF RISK (p. 1053). A. Price risk. 1. The uncertainty about the future price of an asset. 2. Firms can be exposed to price risk with existing assets, such as financial securities or inventory, or with assets to be acquired in the future, such as equipment to be purchased. B. Credit risk. 1. The uncertainty that the party on the other side of an agreement will abide by the terms of the agreement. 2. A common example is the uncertainty over whether a credit customer will ultimately pay his or her account. 3. The success or failure of a bank depends largely on how good the bank's credit analysts are at identifying who will repay a loan. C. Interest rate risk. 1. The uncertainty about future interest rates and their impact on future cash flows as well as on the fair value of existing assets and liabilities. 2. An example is the periodic interest payments on the variablerate mortgage as they will fluctuate in the future depending on the level of future interest rates. 3. A fixed-rate mortgage is another example of a type of interest rate risk. a. If interest rates decrease, then the present value of future fixed payments to be made under a fixed-rate mortgage will increase. b. Thus, the fair value of the mortgage liability increases--this is the downside of obligating yourself to a fixed stream of interest payments when there is a possibility that interest rates may go down. 4. So, interest rate risk exposes a firm to uncertainty about future cash flows as well as uncertainty about the fair value of assets and liabilities that have values tied to the level of interest rates. D. Exchange rate risk.
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6 1. 2. The uncertainty about future U.S. dollar cash flows arising when assets and liabilities are denominated in a foreign currency. Many compensation packages for U.S. citizens working in foreign countries include an end-of-contract bonus payment if the employee stays on the assignment for the length of the contract. a. If this bonus is denominated in the foreign currency, then the employee knows with certainty the amount of the bonus. b. However, if denominated in U.S. dollars, the bonus' value depends on the exchange rate prevailing when the bonus is received. c. Multinational firms face these same risks when sales, purchases, loans, and investments are denominated in foreign currencies.
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TYPES OF DERIVATIVES (p. 1054). A. Swap. 1. A contract in which two parties agree to exchange payments in the future based on the movement of some agreed-upon price or rate. 2. An interest rate swap. a. Two parties agree to exchange future interest payments on a given loan amount. b. Usually, one set of interest payments is based on a fixed interest rate and the other is based on a variable interest rate. c. Example, Pratt Company, p. 1054. B. Forward contract. 1. An agreement between two parties to exchange a specified amount of a commodity, security, or foreign currency at a specified date in the future with the price or exchange rate being set now. 2. Example, Clayton Company and Maruta Company, p. 1055. 3. Some products and certain transactions are routinely negotiated in terms of a certain currency. 4. If denominating a sale in a certain currency will make the customer feel more comfortable, companies are also likely to accommodate. C. Futures contract.
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7 1. 2. A contract, traded on an exchange, that allows a company to buy a specified quantity of a commodity or a financial security at a specified price on a specified future date. Very similar to a forward contract with the difference being that a forward contract is a private contract negotiated between two parties, whereas a futures contract is a standardized contract that is sponsored by a trading exchange and can be traded among different parties many times in a single day. So, with a forward contract, you know the party with whom you will be exchanging cash to settle the contract. With a futures contract, all these cash settlements are handled through the exchange and you never know, or care, who is on the other side of the contract. Example, Hyrum Bakery, p. 1056.
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D. Option. 1. A contract giving the owner the right, but not the obligation, to buy or sell an asset at a specified price any time during a specified period in the future. 2. Options come in two general types. a. Call option--gives the owner the right to buy an asset at a specified price. b. Put option--gives the owner the right to sell an asset at a specified price. 3. In exchange for the rights inherent in the option, the owner of the option pays an amount, in advance, to the party on the other side of the transaction who is called the writer of the option. 4. Like a futures contract, many options are standardized contracts that are traded on organized exchanges. 5. An option differs from the derivatives previously discussed because it protects the owner against unfavorable movements in prices or rates while allowing the owner to benefit from favorable movements. 6. Because of the asymmetrical nature of options, the owner of an option and the writer of an option are in very different positions. a. With a call option, the owner can buy the designated asset at a fixed price, no matter how high the market price goes. (1) If the price decreases, the owner can just discard the option because it can be purchased cheaper. (2) So, the most the owner can lose is the price paid to buy the option. b. The writer of the option has no such downside protection. (1) No matter how high market prices increase, the writer of a call option must sell the asset at the fixed option price.
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8 (2) So, there is no limit to the amount that a call option writer can lose. 7. Example, Woodruff Company, p. 1057. IV. TYPES OF HEDGING ACTIVITIES (p. 1058). A. Hedging. 1. The structuring of transactions to reduce risk. 2. Occurs naturally as part of many business activities. a. In the retail sale of gasoline, the increase in the cost is offset by the increase in the selling price. b. Banks are vulnerable to interest rate increases but can hedge against this by raising the rates they charge on loans. c. Multinational companies are impacted by changes in exchange rates. But any losses are partially offset because the dollar value of their subsidiaries' foreigndenominated liabilities will also decline. B. Derivatives. 1. Can be used in hedging activities through the acquisition of a derivative with the characteristic that changes in the value of the derivative are expected to offset changes in the value of the item being hedged. 2. Previous text examples of derivatives were used as hedges. a. Pratt swap--the interest rate swap was structured to offset changes in the variable-rate interest payments. b. Clayton forward--the forward currency contract was entered into to offset changes in the dollar value of the receivable denominated in Japanese yen. c. Hyrum future--the wheat futures contract was acquired to offset movements in the expected purchase price of the following month's supply of wheat. d. Woodruff option--the gold call option was purchased to offset the negative impact on the cost of gold for production purposes of changes in the market price of gold.
C. The FASB has defined two broad categories of hedging activities. 1. Fair value hedges. a. A derivative that offsets, at least partially, the change in the fair value of an asset or liability. b. A derivative can also serve as a hedge of the fair value of firm commitments even though the assets and liabilities associated with a firm commitment are not recognized until the actual transaction date.
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9 2. 3. Cash flow hedges--a derivative that offsets, at least partially, the variability in cash flows from forecasted transactions that are probable. A third category related to foreign currency risk is also identified. Some are fair value hedges, some are cash flow hedges.
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ACCOUNTING FOR DERIVATIVES AND FOR HEDGING ACTIVITIES (p. 1059). A. Several factors combined in 1993 and 1994 to move the accounting for derivatives to the top of the FASB's agenda. 1. The tremendous proliferation in their use by U.S. businesses. 2. The derivative-related catastrophes experienced by companies. 3. The urging of the SEC for improvement in the accounting for derivatives. 4. Statement No. 119, October 1994. a. Its main focus was on improved disclosure (not recognition) for the 1994 fiscal year. b. Viewed as a temporary stopgap standard. 5. The FASB's June 1996 Exposure Draft was a more comprehensive recognition standard for derivatives. 6. Final standard, SFAS 133, delayed the implementation date until 2000 because of Y2K concerns and the complexity of implementing the standard.
B. Overview of accounting for derivatives and hedging activities. 1. FASB approach based on: a. Balance sheet--reported in balance sheet at fair value as of the balance sheet date. b. Income statement--when a derivative is used to hedge risk, gains and losses on the derivative should be reported in the same income statement in which the income effects of the hedged item are reported. 2. A consequence of this approach is that changes the in fair value of derivatives must also be recognized. The appropriate treatment of these changes depends on whether the derivative serves as a hedge, and the type of hedge, as follows: a. No hedge (1) All changes in the fair value of derivatives that are not designated as hedges are recognized as gains or losses in the income statement in the period in which the value changes. (2) These can be considered as speculation about the direction of movement of some price or rate. b. Fair value hedge.
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10 (1) Changes in the fair value of derivatives designated as fair value hedges are recognized as gains or losses in the period of the value change. (2) These derivative gains/losses are offset (either in whole or part) by the recognition of gains/losses on the change in fair value of the item being hedged. (3) The net effect is that when gains/losses on derivatives designated as fair value hedges exceed the gains/losses on the item being hedged, the excess affects reported net income. c. Cash flow hedge. (1) Changes in the fair value of derivatives designated as cash flow hedges are recognized as part of comprehensive income. (2) In effect, this treatment defers recognition of the gain/loss and classifies the deferred item as an equity adjustment. (3) These deferred derivative gains/losses are recognized in net income in the period in which the hedged cash flow transaction was forecasted to occur. 3. Derivatives must be identified as hedges of specific items at the beginning of the hedging relationship. a. Firms cannot defer this decision until they see the period's results. b. The designation of the derivative as a hedge should be supported with formal documentation. 4. Disclosure. a. Firms must provide a description of their risk management strategy and how derivatives fit into that strategy. b. Firms must disclose the gains/losses on derivatives, separated by category. (1) For both fair value and cash flow hedges, companies must disclose the amount of derivative gains or losses included on income statement because of hedge ineffectiveness. (2) For cash flow hedges, firms must disclose the transactions that can cause deferred derivative gains or losses to be recognized in net income, as well as to disclose deferred gain and losses to be recognized in the next 12 months. c. The notional amount of the derivative instrument is also sometimes disclosed. (1) The notional amount is the total face amount of the asset or liability that underlies the derivative contract.
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11 (2) With a forward contract, the notional amount is the U.S. dollar amount of the commodity or currency to be exchanged. (3) Notional amounts are frequently misleading as they grossly overstate both the fair value and the potential cash flows of derivatives. C. Illustrations of accounting for derivatives and hedging activities. 1. Pratt swap. a. A variable-rate loan and an interest rate swap agreement. b. The value changes in a derivative designated as a cash flow hedge are deferred in comprehensive income and then reflected in earnings in the period when the hedged cash flow occurs. c. Disclosure. Information is shown on page 1062. 2. Clayton forward. a. A yen forward contract. b. Disclosure information is shown on p. 1063. 3. Hyrum future. a. A futures contract and hedge against potential fluctuations in price of wheat. b. Disclosure information is shown on pp. 1064 and 1065. 4. Woodruff option. a. Purchased a call option to buy gold some time before January 1, 2003. b. Disclosure information is shown on pp. 1065 and 1066.
V.
SUMMARY (p. 1066). A. B. C. Derivatives are recognized as assets and liabilities and reported at fair value. For a fair value hedge, changes in fair value are included in earnings and offset against changes in fair value of hedged items. For a cash flow hedge, gains and losses are deferred in comprehensive income and recognized in earnings on the forecasted date of the hedge transaction. IAS 39 is very similar to SFAS 133, and is effective for fiscal years that start on or after January 1, 2001.
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CONTINGENCIES
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12 I. ACCOUNTING FOR CONTINGENCIES: PROBABLE, POSSIBLE, AND REMOTE (p. 1067). A. A contingency as defined in FASB Statement No. 5: 1. ". . . an existing condition, situation, or set of circumstances involving uncertainty as to possible gain . . . or loss . . . to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur." 2. Contingent losses--circumstances involving potential losses that will not be resolved until some future event occurs. 3. Contingent gains--circumstances involving potential gains that will not be resolved until some future event occurs. 4. Refer to Exhibit 18-1 for the important terms, their definitions, and the accounting actions recommended. B. If the occurrence of an event that would create a liability is probable and if the amount of the obligation can be reasonably estimated, the contingency should be recognized as a liability. 1. Many estimated liabilities are in reality probable contingent liabilities, because the existence of the obligation is dependent on some future event occurring. 2. For example, the estimated amount of warranty liability is a probable contingent liability because warranties are dependent on the need to provide future repairs or service. 3. In addition, the pension obligation is dependent on employees staying with the company long enough to earn full pension benefits. Probable gains are not disclosed in order to avoid any misleading implications about the likelihood that the gain will eventually be realized. If a contingent liability is reasonably possible, it should be disclosed in a note to the financial statements. If a contingent item is remote, there is no requirement that the item be disclosed, unless it is a contingent liability under a guarantee arrangement such as co-signing the loan of another party. FASB Statement No. 5 does not provide specific guidelines as to how the terms probable, possible, and remote should be interpreted in terms of probability percentages. 1. Surveys of statement preparers reveal a great diversity in the numerical interpretations of the probability terms used in Statement No. 5. 2. Thus, the contingency standard is very difficult to apply in practice.
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ACCOUNTING FOR LAWSUITS (p. 1069). A. A lawsuit takes a long time to wind its way through courts and appeals. 1. Thus, both the amount and timing of a loss arising from litigation are generally highly uncertain. 2. Some companies carry insurance to protect themselves from these losses, so the impact of the losses on the financial statements can be minimized. 3. For uninsured risks, however, a decision must be made as to when the liability for litigation becomes probable, and thus a recorded loss. 4. FASB Statement No. 5 identifies several key factors to consider in making this decision: a. The nature of the lawsuit. b. Progress of the case in court, including progress between date of the financial statements and their issuance date. c. Views of legal counsel as to the probability of loss. d. Prior experience with similar cases. e. Management's intended response to the lawsuit. 5. If analysis results in the judgment that a loss is probable and the amount can be reasonably estimated, the liability should be recorded. 6. A settlement after the balance sheet date but before the statements are issued would be evidence that the loss was probable at year-end, and it would result in a reporting of a loss in the current financial statements. B. Another area of potential liability involves unasserted claims. 1. A cause of action has occurred but no claim has yet been asserted. 2. If it is probable that a substantiated claim will be filed and upheld and the amount of the claim can be reasonably estimated, accrual of the liability should be made. 3. If the amount cannot be reasonably estimated, note disclosure is required. 4. If assertion of the claim is judged not to be at least reasonably possible, no accrual or disclosure is necessary. 5. A company would be very unlikely to record a loss from unasserted claims or from pending litigation unless negotiations for a settlement had been substantially completed (now the loss is no longer a contingency but an estimated loss). C. Disclosure.
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14 1. Some companies provide no information regarding potential liabilities from lawsuits. 2. Others provide a brief description of pending lawsuits. 3. Sometimes companies provide fairly specific information about pending legal actions and claims. 4. Companies must be careful not to increase their chances of losing pending lawsuits, and they generally do not disclose dollar amounts of potential losses, which might be interpreted as an admission of guilt and a willingness to pay a certain amount. III. ACCOUNTING FOR ENVIRONMENTAL LIABILITIES (p. 1071). A. There is an increased awareness of the need to protect our environment, and in many instances to recover from past environmental abuses. 1. These are associated with staggering costs for environmental liabilities. 2. Many, if not most, companies do not fully reflect these costs in their financial statements. 3. These loss contingencies cannot be reasonably estimated. 4. FASB Statement No. 5 does not give specific guidance on the types of disclosure required when a loss contingency cannot be estimated. 5. So, disclosure in financial statement notes often appears incomplete. Concern exists that financial statement users were not getting enough information about firms' potential environmental liabilities. 1. The SEC has stepped up its requirement for disclosure in the 10-K filing. 2. Accounting standard setters have issued several statements and exposure drafts designed to improve the environmental liability information reported. 3. The SEC issued SAB No. 92, which sets forth the Staff's interpretation of GAAP regarding contingent liabilities. 4. In 1996, the AICPA issued SOP 96-1, outlining key events that can be used to determine whether an environmental liability is probable. 5. The FASB has done some preliminary work to improve the accounting for environmental remediation costs.
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C. Several trends in this effort have been noticed. 1. An increasing number of companies have established committees to oversee environmental compliance. 2. More companies now have written environmental accounting policies, which are disclosed in the accounting policies note to the financial statements. 14
15 3. 4. Finally, there is a heightened awareness of the need for improving environmental liability accounting. It is likely there will be further accounting developments and increased financial disclosures of environmental liabilities in the future.
SEGMENT REPORTING I. BUSINESS SEGMENTS (p. 1074). A. FASB Statement No. 14 in 1976 refined and made mandatory segment disclosure rules. 1. Information to be disclosed includes revenues, operating profit, and identifiable assets for each significant industry segment of a company. 2. Statement No. 14 also requires disclosure of revenues from major customers and information about foreign operations and export sales.
B. FASB Statement No. 131 added the following disclosure requirements. 1. Total segment operating profit or loss. 2. Amounts of certain income statement items such as operating revenues, depreciation, research and development, interest revenue, interest expense, tax expense, and significant noncash expenses. 3. Total segment assets and liabilities. 4. Total capital expenditures. 5. Reconciliation of the sum of segment totals to the company total for each of the following items: a. Revenues. b. Operating profit. c. Assets. 6. Firms must also disclose how operating segments are identified. a. They must use the same criteria, whatever they might be, used by management to distinguish business segments for internal reporting purposes. b. The objective is to provide external users with the same type of information about business segments that is used internally. c. For companies with many internally reportable segments, SFAS No. 131 retained SFAS No. 14 tests for a reportable segment. (1) Revenue test. (2) Profit test. (3) Asset test.
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16 For firms defining their segments along product lines, the Statement No. 131 requires additional disclosure of revenues, capital assets, and long-lived assets for each individual country in which significant operations occur. e. For firms defining their segments geographically, additional revenue information must be disclosed by product line. 7. Difference between Statement No. 131 and Statement No. 14. a. The way firms must identify reportable segments. b. Selected segment disclosure in the interim reports. 8. U.S. and Canadian standards regarding segment reporting are nearly identical, and the revised international standard is similar. D. Application of accounting principles to individual segments of a business presents some unique problems. 1. For example, if a firm uses LIFO and all the inventory is part of one LIFO pool for financial reporting purposes, how is LIFO to be applied in calculating cost of goods sold for individual segments? 2. Another example is the allocation of income tax expense to different segments when the income tax return is prepared for the entire company as a whole. 3. Because of these difficulties, Statement No. 131 states that, for segment reporting purposes, firms are to report to external users using the same accounting practices that are used for internal purposes. 4. This means that the financial data reported in the segment disclosures won't always conform with GAAP. 5. The FASB sees this as part of the price to be paid to reduce the incremental bookkeeping cost required for the firms to provide segment information. d.
INTERIM REPORTING I. INTERIM REPORTS (p. 1077). A. Interim financial statements. 1. Statements showing financial position and operating results for an interval of less than a year. 2. Considered essential in providing investors and others with timely information as to the position and progress of an enterprise. 3. There are significant difficulties associated with them. a. One problem is caused by the seasonal factors of certain businesses.
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17 b. In some companies, revenues fluctuate widely among interim periods. c. In others, significant fixed costs are incurred during a single period but are to benefit several periods. d. So, not only must costs be allocated to appropriate periods of benefit, but they must be matched against the realized revenues for the interim period to determine a reasonable income measurement. 4. In preparing interim reports, adjustments for accrued items, generally required at year-end, have to be considered at the end of each interim period. a. Because of the time and cost involved, many estimates of expenses are made. b. The increased number of estimates adds an element of subjectivity. c. Also, extraordinary items or the disposal of a business segment will have a greater impact on an interim period's earnings than on the results of operations for an entire year. 5. Two viewpoints exist in relation to the reporting of interim results. a. One, that each reporting interval is to be recognized as a separate accounting period. (1) Thus, the results of operations for each interim period are determined in the same manner as for the annual accounting period. (2) The same judgments, estimations, accruals, and deferrals are recognized at the end of each interim period as for the annual period. b. Two, and the one accepted by the APB in Opinion No. 28, is that the interim period is an integral part of the annual period. (1) Essentially, the revenues and expenses for the total period are allocated among interim periods on some reasonable basis, e.g., time, sales volume, or productive activity. (2) Under the integral part of annual period concept, the same general accounting principles and reporting practices employed for annual reports are to be utilized for interim statements, but modifications may be required so the interim reports will better relate to the total results of operations for the annual period. c. Another example of a required modification deals with a change in accounting principle during an interim period. (1) These changes should follow the provisions of APB Opinion No. 20.
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18 (2) However, the FASB concluded in Statement No. 3 that for any cumulative effect-type change, other than a change to LIFO, if the change is made "in other than the first interim period of an enterprise's fiscal year, the cumulative effect of the change on retained earnings at the beginning of the year shall be included in the determination of net income of the first interim period of the year of change." B. Illustration of added insight that quarterly information can provide with quarterly data for the Boston Celtics (Exhibit 18-5).
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