Principles of Corporate Finance Conceptual Framework for Financial Re

Questions: (1) Using the Codification, look up the treatment for extraordinary items in the income statement. a. How are they treated under current GAAP? b. A new GAAP pronouncement will change their treatment moving forward (pending content). What will be the new treatment for these items in the income statement? (2) For each of the items in the Adjusted EBITDA-to-GAAP reconciliation, provide a persuasive argument (about a paragraph for each item) as to whether it should be included in or excluded from an informative income measure for Twitter. In other words, is the income measure more informative with or without each of them, and why? (3) Compare and contrast the reconciling items in the Adjusted EBITDA-to-GAAP reconciliation to those in the Non-GAAP income-to-GAAP reconciliation. a. For each reconciling item, discuss their differences in measurement. b. Do the Non-GAAP income-to-GAAP reconciling items seem more or less justifiable to exclude from income than those in the Adjusted EBITDA-to-GAAP reconciliation? Which ones seem more defensible, and what arguments would support their exclusion from income? (4) For Twitter, do you believe that the inclusion of these supplemental measures make the financial report harder to understand or more useful to users of the information? Why do you think so? Explain fully. (HINT: dont just take managements word for it; think about what you, as a user, believe.) (5) Why, in your view, did management choose to report the Other financial data non-GAAP measures? What was management trying to convey to users of the annual report that the users would not see from measured GAAP income? Answers: 1: Current GAAP Requirements: An Extra Ordinary item can be defined as such a transaction that is unusual and is not expected to recur in the near near future, per Subtopic 225-20 of the Income Statement Extraordinary and Unusual items. As per the existing provision, entities were required to report the extra ordinary items that are both unusual and infrequent. Such a provision implies that all matters that forms part of the business needs to be reported. Such events or transactions have to be separately reported from the results from ordinary transactions and the taxes on such extraordinary items have to be reported separately (Tysiac, 2015). The Earnings Per share on the extra ordinary items also has to be separately disclosed. This is in tune to the policy of disclosure and creates a better impression when it comes to display of information (Tysiac, 2015). To satisfy all these requirements, preparers were spending lot of time and efforts in the identification of the extraordinary items and the relevant disclosures about the same. Amendment Provision: FASB introduced the Accounting Standards Update 2015-01 on 9 January 2015. As per the amendment, business entities will have to no longer report such transactions that are so rare to be classified under extraordinary items. The amendment requires entities to report items that are unusual or rare on the income statement and in the footnotes. Thus, items can no longer be extraordinary under the US GAAP (Seilber, 2015). This amendment is intended to reduce the complexity of the financial statements and the associated costs while retaining the usefulness of the financial statements. The amendment has taken off the pressure from the financial statements and provided a balanced approach. The presence of information in excess makes the financial statement complex in nature that was eliminated by the amendment (Landsman et. al, 2014). In the income statement, these items of unusual nature are separately classified from the operating revenues and ordinary incomes. A similar presentation of such unusual items is also required per the amendment. 2: The Financial Statements are prepared per the GAAP provisions that have displayed a Net Loss for all the years commencing 2010 until date. Adjusted EBITDA is not prescribed by any Accounting Standards or SEC guidelines, but it is a financial metric that is widely used by the investing community for valuation and comparison purposes in the industry. Going by its use and help, it is utilized by the industry (Seilber, 2015). Hence, it is a non-GAAP measure to assess the performance of the company. Different companies might calculate Adjusted EBITDS differently and so its usefulness as an analytical tool is limited to the respective company and its comparison over the years. The years are a big consideration because accordingly the comparison will be done (Brealey et. al, 2014). In this reconciliation, each item is discussed as below: Stock Based Compensation expense This is typically granted to the employees as a part of their employment package subject to the fulfillment of terms and conditions. This item has been correctly reflected in the reconciliation to make adjusted EBITDA a more meaningful figure. Therefore, the presence of this item in the reconciliation process is beneficial to the end users. Depreciation and Amortization expenses As these are non-cash expenses, it is right to include this in the reconciliation (IASB, 2011). Interest and Other expenses (Net) As the name itself depicts, EBITDA means Earnings before Interest, Taxes, Depreciation and Amortization, it is apt to include this item in the reconciliation as this is a cost for maintaining the liquidity and funds flow in the company (Laux, 2014). Provision (benefit) for income taxes - This is again an item of no cash expenditure and hence it is rightly classified under the reconciliation of Adjusted EBITDA to GAAP Income / (Loss). Upon removal of all these items, the operating incomes / losses of the company can be known. As we can see that, the Income statement displays a Net Loss but Adjusted EBITDA is a positive figure that indicates that the business is still running profitably and it is only the additional non-operating expenses that have converted the profit into a loss. This information and analysis is meaningful for the investors, revenue authorities and all other stakeholders. This figure is considered by stakeholders to evaluate the financial condition of the business and helps in computation of various ratios that provides a great reflection on the company is working. 3: Non-GAAP to GAAP income Reconciliation: The analysis of the items that have gone into the Non GAAP Net Income / Loss calculation is done below: Stock based Compensation Expenses This item is the same as displayed in Adjusted EBITDA calculation. For evaluating the financial and operating results and decision making, this item has been specifically excluded which is also a fair treatment since the stock options are independent of the company operations. This is a proper act and hence, tends to provide a figure that is not over burdened. Amortization of Acquired Intangible Assets Under the Adjusted EBITDA, Depreciation and Amortization of all the assets has been excluded but under Non GAAP Income reconciliation, only the amortization elated to intangible acquired assets is excluded which signifies that GAAP has special tax provisions in relation to the acquired intangible assets and so it is apt to classify this as a separate line item (IASB, 2011). Non-Cash Interest Expenses relatable to Convertible Notes Convertible Notes are those that are converted to Equity Shares or Debentures upon completion of a specific period. Apart from the interest payable on these notes, there is a possibility of incurring some transfer expenses and such other non-cash expenses which are recorded by means of a book entry and not actually paid in cash. For these reasons, this item is also not directly relatable to the operations of the company and so it is excluded. The items those are not directly associated should be eliminated as it will provide a clear-cut figure and helps in proper assessment. Income Tax Effects related to acquisitions By acquiring a subsidiary, the benefit of the carry forward and set off losses is available. These are the items for which there is no virtual cash outflow from the company but it is only seen as a benefit or in the form of tax savings. Hence, this item is also excluded from the Non GAAP Reconciliation. Moreover, this item is not in a direct form and exclusion is the best method (IASB, 2010). From a comparison of the Adjusted EBITDA Reconciliation with Non GAAP Income reconciliation, it can be observed that though both these are just different financial metrics to better enhance the usefulness of the financial statements, the Non GAAP Income Reconciliation is more prone on the exact non cash expenses and does not include the complete interest expense or the overall income tax provisions, it has just taken a portion from the same (Deegan, 2011). Thus, the Non GAAP Income Reconciliation is a fairer estimate of the sole company operations upon exclusion of the amortization of acquired intangibles, Non Cash Interest expenses and Tax effects related to acquisitions (Leo, 2011). 4: For a person with financial knowledge and the ability to interpret financial statements, these items would be meaningful in the sense that the Non GAAP Income / Loss indicates the business trends upon the removal of the disguised expenses and thus helps in financial analysis and decision making. The Adjusted EBITDA is more or less similar to the EBITDA except for the fact that the Stock based compensations are excluded (Horngren, 2013). These items do not make financial statements harder; on the contrary, it provides more scope for comparison and analysis on a year-to-year basis and understands the direction the company is adopting by a careful study of these expenses. 5: The Section of Other Financial Data Non GAAP measures is available since the financial statements are prepared strictly as per the GAAP provisions and the Net Income / (Loss) has been indicated on an accrual basis (Needles Powers, 2013). However, as we know that the Cash Flow Statement is indicative of the exact cash difficulties in the company, similarly the other financial data measures are also for financial analysis purpose. There could be cases where the Income Statement is showing a Profit but there is a Net Decrease in the Cash and Cash equivalents and vice versa. It is the case with Other Financial Data; the Adjusted EBITDA is a positive figure indicating an Income despite the Income Statement showing a Loss. Without the calculations, workings and interpretations, it is almost impossible to interpret the Other Financial Information numbers on the face of the Income Statement. Thus it is right on the part of the management to display these figures which are Non GAAP measur es but also informative and of much utility for the stakeholders (Needles Powers, 2013). Providing such figures will lead to better transparency and helps in providing high-level information to the end users. This will aid in decision-making process and will help in the long run. Moreover, the company will gain advantage in terms of proper disclosures and providing a strong set of information. References Brealey, R, Myers, S. Allen, F. (2014). Principles of corporate finance. New York: McGraw-Hill/Irwin. Deegan, C. M., (2011). In Financial accounting theory. North Ryde, N.S.W: McGraw-Hill Horngren, C., (2013). Financial accounting. Frenchs Forest, N.S.W: Pearson Australia Group IASB (2010). The Conceptual Framework for Financial Reporting, Retrieved February 12 2016, from https://eifrs.ifrs.org IASB (2011). International Financial Reporting Standard 13. Fair Value Measurement, Retrieved February 12 2016, from https://eifrs.ifrs.org Landsman, W. R., Maydew, E. L., Thornock, J. R. (2014). The information content of annual earnings announcements and mandatory adoption of IFRS. Journal of Accounting and Economics, 53, 34-54. Laux, B. (2014). Discussion of The role of revenue recognition in performance reporting. Accounting and Business Research, 44(4), 380-382. Leo, Ken J. (2011). Company Accounting, Boston:McGraw Hill Needles, Belverd E Powers, Maria. (2013). Principles of Financial Accounting. Financial Accounting Series, Cengage Learning. Seilber, Jay. (2015, January 12). FASB removes concept of extraordinary, retains guidance on unusual item, Retrieved February 12 2016, from https://www.pwc.com/us/en/cfodirect/assets/pdf/in-brief/us2015-01-fasb-extraordinary-unusual-items.pdf Tysiac , Ken. (2015, January 14). No more extraordinary items: FASB simplifies GAAP, Retrieved February 12 2016, from https://www.journalofaccountancy.com/news/2015/jan/gaap-extraordinary-items-201511630.html