Earnings are extremely important to a publicly traded company and the creditors and investors of that company. However, looking at earnings without regard to the quality of those earnings is hazardous to the health of creditors and investors.
1. Why is the determination of earnings quality and persistence important?
2. Explain recasting of the income statement and give three examples of items that are recasted.
3. Explain adjusting of the income statement and give three examples of items that are recasted.
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The determination of earnings quality and persistence is important. First, earnings quality is the reasonableness of an organization's earnings. Reasonableness means that the reported earnings come from normal operations rather than extraordinary events, controllable and ...
The determination of earnings quality and persistence is highlighted.
INTEGRATIVE CASE 7.1 Starbucks Case
Please answer the questions A-E for this case.
INTEGRATIVE CASE 7.1
Part 1-Accounting Policy
Presented below are excerpts from Note 1 to Starbucks' September 28, 2008, Consolidated
Financial Statements in which Starbucks describes accounting policy for long-lived assets.
Excerpts from Note 1:"Summary of Significant Accounting Policies"
Property, Plant and Equipment
Property, plant and equipment are carried at cost less accumulated depreciation. Depreciation of property, plant and equipment, which includes assets under capital leases, is provided on the straight-line method over estimated useful lives, generally ranging from two to seven years for equipment and 30 to 40 years for buildings. Leasehold improvements are amortized over the shorter of their estimated useful lives or the related lease life, generally 10 years. For leases with renewal periods at the Company's option, Starbucks generally uses the original lease term, excluding renewal option periods, to determine estimated useful lives. If failure to exercise a renewal option imposes an economic penalty to Starbucks, management may deter mine at the inception of the lease that renewal is reasonably assured and include the renewal option period in the determination of appropriate estimated useful lives.The portion of depreciation expense related to production and distribution facilities is included in "'Cost of sales including occupancy costs" on the consolidated statements of earnings. The costs of repairs and maintenance are expensed when incurred, while expenditures for refurbishments and improvements that significantly add to the pro ductive capacity or extend the useful life of an asset are capitalized.When assets are retired or sold, the asset cost and related accumulated depreciation are eliminated with any remaining gain or loss reflected in net earnings.
Goodwill and Other Intangible Assets
Goodwill and other intangible assets are tested for impairment annually and more frequently if facts and circumstances indicate goodwill carrying values exceed estimated reporting unit fair values and if indefinite useful lives are no longer appropri ate for the Company's trademarks. Based on the impairment tests performed, there was no impairment of goodwill or other intangible assets in fiscal 2008, 2007 and 2006. Definite-lived intangibles, which mainly consist of contract-based patents and copyrights, are amortized over their estimated useful lives. For further information on goodwill and other intangible assets, see Note 9.
When facts and circumstances indicate that the carrying values of long-lived assets may be impaired, an evaluation of recoverability is performed by comparing the carrying values of the assets to projected undiscounted future cash flows in addition to other quantitative and qualitative analyses. Upon indication that the carrying values of such assets may not be recoverable, the Company recognizes an impairment loss by a charge to net earnings.The fair value of the assets is estimated using the discounted future cash flows of the assets. Property, plant and equipment assets are grouped at the lowest level for which there are identifiable cash flows when assessing impairment Cash flows for retail assets are identified at the individual store level. Long-lived assets to be disposed of are reported at the lower of their carrying amount, or fair value less estimated costs to sell.
The Company recognized net impairment and disposition losses of $325.0 million, $26.0 million and $19.6 million in fiscal 2008, 2007 and 2006, respectively, due to underperforming Company-operated retail stores, as well as renovation and remodeling activity in the normal course of business. The net losses in fiscal 2008 include $201.6 million of asset impairments related to the US and Australia store closures and charges incurred for office facilities no longer occupied by the Company due to the reduction in positions within Starbucks leadership structure and non-store organization.See Note 3 for further details. Depending on the under lying asset that is impaired, these losses may be recorded in any one of the operating expense lines on the consolidated statements of earnings: for retail operations, these losses are recorded in "Restructuring charges" and "Store operating expenses; for specialty operations, these losses are recorded in "Other operating expenses"; and for all other operations, these losses are recorded in "Cost of sales including occupancy costs," "General and administrative expenses," or "Restructuring charges?'
Research and Development
Starbucks expenses research and development costs as they are incurred. The Company spent approximately$7.2 million, $7.0 million and $6.5 million duringfis cal2008, 2007 and 2006, respectively, on technical research and development activities, in addition to customary product testing and product and process improvements in all areas of its business.
Asset Retirement Obligations
Starbucks accounts for asset retirement obligations under FASB Interpretation No.
47 ("FIN 47"), "Accounting for Conditional Asset Retirement Obligations-an interpretation of FASB Statement No. 143," which it adopted at the end of fiscal 2006. FIN 47 requires recognition of a liability for the fair value of a required asset retirement obligation (''ARO") when such obligation is incurred. The Company's AROs are primarily associated with leasehold improvements which, at the end of a lease, the Company is contractually obligated to remove in order to comply with the lease agreement. At the inception of a lease with such conditions, the Company records an ARO liability and a corresponding capital asset in an amount equal to the estimated fair value of the obligation. The liability is estimated based on a number of assumptions requiring management's judgment, including store closing costs, cost inflation rates and discount rates, and is accredited to its projected future value over time. The capitalized asset is depreciated using the convention for depredation of leasehold improvement assets. Upon satisfaction of the ARO conditions, any differ ence between the recorded ARO liability and the actual retirement costs incurred is recognized as an operating gain or loss in the consolidated statements of earnings. ARO expense was $6.5 million and $4.2 million, in fiscal 2008 and 2007, respec tively, with components included in "'Costs of sales including occupancy costs," and "Depreciation and amortization expenses':The initial impact of adopting FIN 47 at the end of fiscal year2006 was a charge of$27.1 million, with a related tax benefit of $9.9 million, for a net expense of $17.2 million, with the net amount recorded as a cumulative effect of a change in accounting principle on the consolidated statement of earnings for fiscal year 2006. As of September 28, 2008 and September 30, 2007, the Company's net ARO asset included in "Property, plant and equipment, net" was $18.5 million and $20.2 million, respectively, while the Company's net ARO liability included in "Other longterm liabilities" was $44.6 million and $43.7 million, as of the same respective dates.
a. Leasehold improvements are substantial costs incurred by Starbucks to outfit, remodel, and improve leased retail outlets.Why does Starbucks capitalize and amortize leasehold improvements? Does its policy for determining useful lives in the presence of a lease renewal option yield high-quality accounting numbers? How would Starbucks account for the leasehold improvement costs remaining at the end of a lease it had expected to renew but did not?
b. Starbucks has anARO related to the leasehold improvements. Describe how Starbucks recognizes the ARO initially in the balance sheet. Then describe how Starbucks recognizes changes in the ARO-related asset and ARO liability in the income statement over time. How is income affected when Starbucks actually spends cash to return a leased property to its original condition? If Starbucks spends more cash than reflected in the ARO liability, how will it account for the difference?
c. How would the first sentence of the Long-lived Assets section of Note 1 appear if
Starbucks followed IFRS? Which system do you believe provides the best quality accounting for long-lived asset impairment?
d. The second paragraph of the long-lived assets section of the note describes how
Starbucks reflects impairment charges in the income statement. Which line item would you prefer that Starbucks use to report the charges? Why?
e. How would the first sentence of Starbucks R&D accounting policy appear if
Starbucks followed IFRS? Do you prefer the IFRS or U.S. GAAP approach to R&D