Tag Archives | GAAP

Proforma Earnings

See Also:
Pro-Forma Financial Statements
Retained Earnings
EBITDA
Operating Income (EBIT)
Financial Ratios

Proforma Earnings Definition

Pro forma earnings are a company’s earnings that exclude rare, extraordinary, or nonrecurring items. Companies may incur expenses that do not reflect typical operating expenses. These expenses, which must be disclosed in financial statements in accordance with GAAP standards, can impact a company’s financial performance in a given accounting period. Proforma earnings exclude these extraordinary expenses in order to provide a clearer picture of the company’s financial performance. You can also call proforma earnings core earnings, operating earnings, or ongoing earnings.

A company’s earnings are a key measure of its financial performance. Creditors and investors examine a company’s earnings to evaluate its financial performance when deciding whether or not to lend to or invest in the company. Compare current period earnings to prior period earnings of the same company to gauge progress over time. Or compare current period earnings to industry peers and competitors to assess the company’s competitive position in the marketplace.

Earnings According to the SEC and GAAP

The SEC requires publicly traded companies to report net income and operating income in financial statements prepared according to GAAP regulations and procedural standards. The investing public scrutinizes these measures of financial performance. However, some businesspeople often consider these income measures to be inaccurate to some degree.

GAAP standards require businesses to include rare, extraordinary, or nonrecurring items in their financial statements. But company executives believe that including these rare, extraordinary, and nonrecurring items in the financial statements obscures the true picture of the company’s financial performance. Therefore, some companies prefer to publish pro forma earnings in their financial statements along with their SEC-required GAAP-standardized earnings.

Proforma Earnings – Explanation

These pro forma earnings, or hypothetical earnings that exclude items deemed rare, extraordinary, or nonrecurring by the individuals preparing the pro forma financial statements, are considered to provide a clearer and more accurate picture of the company’s financial performance for the relevant accounting period. For example, when prepared in accordance with GAAP regulations, a company may show a loss for a given accounting period. However, during that same period, a company can show a profit in its pro forma earnings.

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Proforma Earnings

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Proforma Earnings

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Net Operating Loss Carryback and Carryforward

Net Operating Loss Carryback and Carryforward

What is a net operating Loss carryback and carryforward? A net operating loss occurs when a company’s operating expenses and allowable tax deductions exceed its operating income for an accounting period. Companies pay taxes on operating income. When companies incur an operating loss, there is no taxable income, so they pay no taxes. According to GAAP, companies can take an operating loss in the current period and use it to offset operating gains in past or future periods.

In the U.S., an operating loss can be “carried-back” to offset operating income from previous periods. Or it can be “carried-forward” to offset operating income in future periods. Companies subtract the amount of the operating loss in one period from operating income in previous or future periods. Then they are able to reduce the taxable income in those periods.

According to GAAP, a net operating loss can be carried-back up to 3 years. That is, apply it to any year within three years prior to the year in which the operating loss is incurred. You can carry-forward a net operating loss up to 7 years. Apply the loss to any year within seven years after the year in which the operating loss is incurred.

Net Operating Loss Carryback and Carryforward

See Also:
Net Sales
Net Income
Allowance for Uncollectible Accounts
Company Life Cycle
Dispersion

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Operating Lease

An operating lease is a short-term off-balance-sheet lease agreement. This type of lease is not recorded on the lessee’s balance sheet. This type of lease typically spans a small portion of the asset’s useful life, and the lessor retains the risks and benefits of ownership. For example, in an operational lease, the lessor is responsible for service and maintenance of the asset throughout the duration of the lease. You can also call it a service lease.

Operating Lease Treatment

According to GAAP, property leased with this kind of lease is not recorded on the lessee’s balance sheet. Lease payments are recorded as rent expenses on the income statement.

Finance Lease versus Operating Lease

There are two main differences between capital (finance) leases and operating leases.

1. With a capital lease, the lessee must record both a lease asset and a lease liability on their balance sheet. With an operating lease, this is not required.

2. With a capital lease, the lessee assumes both the risks and benefits of owning the asset. With an operating lease, the lessor retains the risks and benefits of owning the asset throughout the duration of the lease.

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Operating Lease
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Operating Lease

See also:

Capital Lease Agreement
Commercial Lease

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Modified Accelerated Cost Recovery System (MACRS)

See Also:
Straight Line Depreciation
Double Declining Depreciation Method
Accelerated Method of Depreciation
Financial Accounting Standards Board (FASB)
Generally Accepted Accounting Principles

Modified Accelerated Cost Recovery System Definition

The modified accelerated cost recovery system (MACRS) method of depreciation assigns specific types of assets to categories with distinct accelerated depreciation schedules. Furthermore, MACRS is required by the IRS for tax reporting but is not approved by GAAP for external reporting.

MACRS Depreciation Calculation

To calculate depreciation for an asset using MACRS, first determine the asset’s classification. Then use the table (below) to find the appropriate depreciation schedule.

When using MACRS, an asset does not have any salvage value. This is because the asset is always depreciated down to zero as the sum of the depreciation rates for each category always adds up to 100%. When calculating depreciation expense for MACRS, always use the original purchase price of the asset as the depreciable base for each period. Note that you depreciate each category for one year longer than its classification period. For example, depreciate an asset classified under 3-Year MACRS for 4 years. Then depreciate an asset classified under 5-Year MACRS for 6 years, and so on.

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MACRS Example

For example, an asset purchased for $100,000 that falls into the 3-Year MACRS category shown below, would be depreciated as follows:

YearDepreciation Rate     Depreciation Expense
  1     33.33%         $33,330     (33.33% x $100,000)
  2     44.45%         $44,450     (44.45% x $100,000)
  3     14.81%         $14,810     (14.81% x $100,000)
  4      7.41%          $7,410     (7.41%   x $100,000)

MACRS Depreciation Table

Below is the table for Half-Year Convention MACRS for 3, 5, 7, 10, 15, and 20 year depreciation schedules.

Depreciation Rates (%)

Year    3-Year    5-Year   7-Year   10-Year  15-Year  20-Year 

  1     33.33     20       14.29    10       5        3.75
  2     44.45     32       24.49    18       9.5      7.219
  3     14.81     19.2     17.49    14.4     8.55     6.677
  4      7.41     11.52    12.49    11.52    7.7      6.177
  5               11.52     8.93     9.22    6.93     5.713
  6                5.76     8.92     7.37    6.23     5.285
  7                         8.93     6.55    5.9      4.888
  8                         4.46     6.55    5.9      4.522
  9                                  6.56    5.91     4.462
 10                                  6.55    5.9      4.461
 11                                  3.28    5.91     4.462
 12                                          5.9      4.461
 13                                          5.91     4.462
 14                                          5.9      4.461
 15                                          5.91     4.462
 16                                          2.95     4.461
 17                                                   4.462
 18                                                   4.461
 19                                                   4.462
 20                                                   4.461
 21                                                   2.231

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Modified Accelerated Cost Recovery System

Modified Accelerated Cost Recovery System

MACRS and the IRS

For more detailed information regarding MACRS, go to: irs.gov/publications

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Marking to Market

See Also:
Dispersion
Financial Instruments
Basis Definition
Basis Points

Marking to Market (Financial Derivatives)

Marking to market refers to the daily settling of gains and losses due to changes in the market value of the security. For financial derivative instruments, such as futures contracts, use marking to market.

If the value of the security goes up on a given trading day, the trader who bought the security (the long position) collects money – equal to the security’s change in value – from the trader who sold the security (the short position). Conversely, if the value of the security goes down on a given trading day, the trader who sold the security collects money from the trader who bought the security. The money is equal to the security’s change in value.

The value of the security at maturity does not change as a result of these daily price fluctuations. However, the parties involved in the contract pay losses and collect gains at the end of each trading day.

Arrange futures contracts using borrowed money via a clearinghouse. At the end of each trading day, the clearinghouse settles the difference in the value of the contract. They do this by adjusting the margin posted by the trading counterparties. The margin is also the collateral.


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Marked to Market (Accounting Treatment)

In accounting, marked to market refers to recording the value of an asset on the balance sheet at its current market value instead of its historical cost.

According to GAAP, record certain assets, such as marketable securities, at market value on the balance sheet because this value is more relevant than historical cost for this type of asset. Gains and losses from marketable securities are reported differently depending on whether the asset is classified as available-for-sale or trading.

Label gains and losses from fluctuations in market value of securities as available-for-sale. Also report these in the other comprehensive income account in the equity section of the balance sheet. Any adjustments from fluctuations in market value of securities labeled trading are reported as unrealized gains or losses on the income statement. For both types of securities, dividends or gains and losses from sale are reported as other income on the income statement.

Unethical accountants might attempt to manipulate net income. They do this by labeling marketable securities as either available-for-sale or trading depending on whether they increased or decreased in value.

Mark to Market Examples

For a financial derivative example, consider two counterparties that enter into a futures contract. The contract includes 10 barrels of oil, at $100 per barrel, with a maturity of 6 months. And the value of the futures contract is $1,000. At the end of the next trading day, the price of oil is $105 per barrel. The trader in the long position collects $50 ($5 per barrel) from the trader in the short position.

For an accounting example, consider a company that has passive investments in two stocks, A and B. Stock A is classified as available-for-sale and is worth $10 per share. But Stock B is classified as trading and is worth $50 per share. At the end of the accounting period, A is worth $15 and B is worth $40.

A gain equal to $5 per share of stock A would be recorded in the other comprehensive income account in the equity section of the company’s balance sheet. The marketable securities account on the asset side of the balance sheet would also increase by that amount. An amount equal to $10 per share of stock B would be recorded as an unrealized loss on the company’s income statement. The marketable securities account would also decrease by that amount.

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marking to market, Marked to Market

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LIFO vs FIFO

See Also:
Inventory Turnover Ratio Analysis
Inventory to Working Capital
Perpetual Inventory System
Just in Time Inventory System
Work in Progress

LIFO vs FIFO – Last In, First Out vs First In, First Out

In the field of accounting, LIFO vs FIFO are two methods of valuing inventory. LIFO assumes the last items acquired are the first sold, and the first items acquired remain in inventory. FIFO assumes the first items acquired are the first sold, and the items acquired most recently remain in inventory. Both methods are approved by GAAP.

The idea is that a company accumulates inventory over time. And the items in inventory were purchased at differing prices. As products are sold, inventory costs move from the balance sheet to the income statement. Accountants have the option of valuing the items sold and the items remaining in inventory according to the oldest or the most recent costs of the inventory.

FIFO and LIFO are merely methods for recording and reporting the cost of inventory and have nothing to do with the actual flow of physical inventory. For example, a company can sell its oldest inventory first, and still use the LIFO method for financial reports.

FIFO Inventory Method

The FIFO inventory method assumes the first items acquired are the first sold, and the items acquired most recently remain in inventory.

A new firm may want to use FIFO to increase the value of the assets on its balance sheet. Assuming prices rise over time, the oldest inventory will be the cheapest. Expensing the oldest inventory first comparatively decreases the cost of goods sold, increases net income, and increases the value of inventory on the balance sheet because the items remaining in inventory are the most recent and costly items.

LIFO Inventory Method

The LIFO inventory method assumes the last items acquired are the first sold. And the first items acquired remain in inventory.

Using LIFO can have tax advantages. Since prices typically rise over time, the most recent inventory acquired is the most expensive. Expensing the most costly inventory will increase the cost of goods sold and decrease the taxable income. Refer to this as the LIFO reserve.

Average Cost Inventory Method

The average cost inventory method is another way to value inventory. This method simply uses the average cost of the items in inventory. In addition, they use this cost to value the items sold as well as the items that remain in inventory. To calculate the average cost of the inventory, divide total cost of goods available for sale by number of units available for sale.

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lifo vs fifo, FIFO Inventory Method, LIFO Inventory Method

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lifo vs fifo, FIFO Inventory Method, LIFO Inventory Method

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Full Disclosure Principle

See also:
Accounting Principles 5, 6, and 7
Accrual Based Accounting GAAP Rules
Generally Accepted Accounting Principles (GAAP)
What is GAAP?

Full Disclosure Principle Definition

As one of the principles in Generally Accepted Accounting Principles (GAAP), the Full Disclosure Principle definition requires that all situations, circumstances, and events that are relevant to financial statement users have to be disclosed. In other words, all of a company’s financial records and transactions have to be available for viewing.

Full Disclosure Principle Example

The Full Disclosure Principle in financial reporting exists so that individuals, from potential investors to executives, can be made aware of the financial situation in which a company exists. Without the Full Disclosure Principle of GAAP, it is likely that companies and organizations would withhold information that could possibly shed negative light on their financial standing. A prime full disclosure principle example of this occurred during the Enron scandal. In this case, particular individuals and investors argued that this principle was violated. It was also argued that Enron withheld and fabricated crucial information to investors that would have made a difference in how these individuals invested in the company.

Full Disclosure Principle Consequences

GAAP designed this principle to protect the safety businessmen and investors. As a result, there are consequences when companies fail to adhere to this rule. In addition to the consequence that investors can be mislead into making unintelligent decisions as a result of withholding financial information, the Securities and Exchange Commission (SEC) also maintains the right to penalize any misbehavior. A company can be fined millions of dollars for any discrepancies or misconduct involved with their financial statements or accounting information.

In one example of this, Worldcom was fined 750 million dollars for reporting inflated income to investors. However, Worldcom was responsible for over 2 billion dollars in financial damages. Therefore, while the financial penalty to Worldcom was substantial, the consequence to the investor was far greater. The penalty for Woldcom was 75 times greater than any previous penalty. Thus, the Worldcom example is showing that the full disclosure principle is intact to prevent nasty consequences from occurring to both companies and the individual investor.

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Full Disclosure, Full Disclosure Principle, Full Disclosure Principle Definition, Full Disclosure Principle Example

Full Disclosure, Full Disclosure Principle, Full Disclosure Principle Definition, Full Disclosure Principle Example

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