Interim Financial Reporting
Stakeholders, like investors, creditors, suppliers, and others, need information about the financial performance of the enterprise. These users cannot wait for the end of the year to do so. They need financial information periodically, at the end of either a month, quarter, or semiannually. This chapter deals with important issues like accounting principles and practices used in the preparation of interim financial statements, and approaches to preparing interim financial statements.
2.2 The Need for Interim Reports
Interim financial reports are defined as reports prepared for a period of less than a year. The purpose of preparing interim financial reports is to meet the needs of decision makers. Decision makers are interested in frequent and timely information about the firm’s financial position and results of operations. Among decision makers lenders are the common users. They need to closely monitor the progress of borrowers so that problems can be identified as early as possible. Another reason for the interest in interim financial reports is to use such reports as a basis for projecting annual results.
An interim financial report may include either a
- Selected financial data
- Complete set of financial statements
Although there is greater need for interim financial reports, there are problems associated in their preparation. Some of them include the following:
- It is difficult to make estimates and judgments as accurately as possible. When the accounting period gets shorter, estimates and judgments cannot be accurately made.
- The treatment of seasonal expenses. i.e. expenses that relate to a full year’s activity but that occur randomly during the year.
2.3 Approaches to Interim Reporting
This relates to the view accountants hold about interim period. Accountants hold two views about interim period. There are:
1. Discrete period approach
It is the approach in which each interim period is treated as a distinct accounting period. Alike annual financial results, the same principles and processes are used in determining interim net income. Under this approach, any outlay such as for advertising, repairs and maintenance would be expensed in the interim period in which the outlay occurs.
2. Integral period approach
It is an approach in which an interim period is considered as an integral part of the annual period. Under this approach, accruals, deferrals, estimates, and allocations depend on overall estimates of the relationship between estimated annual revenues and expenses. Expenses, such as advertising and research and development costs will be deferred so that a proper allocation between interim periods within one year can be achieved.
According to Accounting Principles Board (APB) opinion No. 28, interims financial statements are based on integral period approach. APB opinion No. 28 also stressed that interim financial statements should be based on the same accounting principles and practices that are used in the preparation of annual financial statements.
2.4 Standards for Interim Reporting of Revenues, Costs, and Expenses
Revenues should be recognized as earned during the interim period on the same basis as followed for the full year. Seasonal variations in revenue should be disclosed by issuing data for the latest 12 months in addition to the interim data.
2. Costs and expense
a. Direct costs and expenses
Costs and expenses may be classified into direct costs, and indirect costs. Direct costs and expenses are those that can be associated with revenues, or directly associated with the products or services provided. They are also called allocated product costs, and include all inventoriable direct costs (i.e. materials, labor, and manufacturing overhead).
For interim periods, direct/allocated costs are treated in the same way as full year. However, APB opinion No. 28 provided the following exceptions with respect to the determination of cost of goods sold for interim financial statements.
- Enterprises that use the gross profit method at interim dates to estimate cost of goods sold should disclose their practice in the interim financial statements.
- Enterprises using the LIFO method of inventory may dig into LIFO layers temporarily during an interim period because LIFO is an annual concept.
- Inventory losses resulting from market declines should not be deferred beyond the interim period in which they occur. If losses are recovered in a subsequent interim period, gains should be recognized to the extent of losses previously recognized. To illustrate, assume that the costs and market value of inventory in the 1st quarter are Br. 10,000 and Br. 7000 respectively. Inventory loss to be reported in the 1st quarter would be Br. 3000 (i.e 10,000 – 7000 = 3000). If inventory value (market value) is Br. 14,000 in the 2nd quarter, gain is Br. 4000, but only Br. 3000 is recognized because loss was Br. 3000 in the 1st quarter.
Inventory losses due to temporary inventory market decline should not be recognized in interim period. (Temporary inventory market decline is a market value decline in one interim period with an expected market recovery in a subsequent interim period within the same fiscal year.
Enterprise using standard cost accounting for the determination of inventory and cost of goods sold should follow the same procedures for interim periods as would apply to the entire fiscal year. The following guidelines may apply to variances.
- Planned or normal variances at the end of the interim period should be deferred at the interim date because they are absorbed by the end of the fiscal year.
- Unplanned or abnormal variances should be shown in the interim period during which they occur.
b. Indirect Costs
Indirect costs represent those costs and expenses other than product cost (direct, or allocated costs). APB opinion No. 28 has indicated the following standards with respect to costs and expenses other than product costs:
- They should be charged to income in interim period as incurred or be allocated among interim period based on an estimate of time expired, benefit received, or activity associated with the periods. The same procedures should be used as annual reporting dates.
- Those costs and expenses that cannot be readily identified with the activities or benefits of other interim periods should be charged to the interim period in which incurred, and disclosures should be made.
- Arbitrary assignment of the amount of indirect costs and expenses to an interim period should not be made.
- Gains and losses that arise in any interim period similar to those that would not be deferred at year-end, should not be deferred to later interim periods within the same fiscal year.
- The above standards apply to such items as major repairs, quantity discounts, property taxes, and advertising costs.
- The above standards encourage enterprises to avoid year-end adjustments as much as possible may making quarterly estimates of items, such as inventory shortages, bad debt expense, and contract adjustments.
2.5 Income Taxes in Interim Financial Statements
The determination of interim operating results requires the estimation of income tax provision for the interim periods. According to APB opinion No. 28, the amount of income tax charged to an interim period should be related to the expected annual income tax provision. To estimate interim income tax, we need to determine the effective tax rate for the entire current fiscal period at the end of each interim period. This effective tax rate is applied into interim income. Interim income tax expense (or benefit) is computed as follows:
The effect of permanent tax differences should be estimated in determining the estimated effective annual tax rate. Permanent tax differences include:
- Percentage of depletion
- Nontaxable income
- Non taxable expense
In determining the estimated effective annual tax rate, we need to exclude the tax effect of non-ordinary items of income or loss because they are sold net of income tax effect. Non ordinary item of income or expense include:
- Extra ordinary items
- Discontinued operations
- Cumulative effect of changes in accounting principles
Suppose that Stars Company has pretax income of Br. 130,000 at the end of the first quarter. Assume further that at the end of the first quarter, Stars estimated that effective annual tax rate is 59%. What is income tax provision for the first quarter?
Tax provision for the 1st quarter is equal to pretax income times estimated effective income tax rate. i.e.
Income tax provision = Pretax income x Estimated effective tax rate
= 130,000 x 59%
To illustrate further, Stars Company had a pretax income of Br. 180,000 for second quarter. Its estimated combined effective tax rate is 55% at the end of the second year. Income tax provision for the second quarter is the difference between year to date tax expense (or benefit) and cumulative amounts of tax reported in the previous interim period. i.e
The above process is repeated for the third and fourth quarters. The effect of a change in the estimated full year tax rate is included in the tax provision of the second quarter. As a result, retroactive revision is not undertaken.
Tax benefit arises when operating result for the quarter turned to be a loss and the realization of tax benefit is assured reasonably. If income tax benefit resulting from operating loss is not reasonably assured, it is not realized.
2.6 Reporting of Accounting Changes and Extra Ordinary and Other Non Operating Items
2.6.1 Reporting extra ordinary and other non operating items
Extra ordinary items are events or transactions that are distinguished by their unusual nature and by the infrequency of their occurrence. Any loss arising from extra ordinary events are shown in the income statement, net of income taxes. Extraordinary and unusual items are reported in full as they occur so that their impact is immediately known i.e. they are shown in the income statement in the interim period in which they occur.
2.6.2 Reporting gains or losses from disposal of business segment
Business segment is a component of a business enterprise whose activities represent a separate major line of business or class of customer. Any gain or loss on the disposal of the segment is reported separately in the income statement, net of the related income tax effects. In interim reports, any gain or loss resulting from disposal of segment is reported in full in the interim period it arises.
2.6.3 Reporting accounting changes in interim periods
Business enterprises are required to use accounting principles consistently so that the financial performance of two periods can be compared. However, management of a business enterprise may justify a change in accounting principles on grounds that it is preferable. There are three types of accounting changes. These are changes in accounting principles, a change in accounting estimates, and a change in reporting entity.
A change in accounting principles generally requires the inclusion of the cumulative effect of change to a new principle in net income of the accounting period in which the change is made. Change in accounting estimates affect only the current and future periods’ financial statements. With regards to reporting accounting changes in interim period, there are two principal provisions.
1. Accounting changes in the First interim period
If a change of accounting principles is made during the first interim period of an enterprise’s fiscal year, the cumulative effect of the change on retained earnings at the beginning of that fiscal year shall be include in net income of the first interim period.
2. Accounting changes in other than the first interim period of an enterprise.
If a change of accounting principle is made in other than the first interim period no cumulative effect of the change shall be included in net income of the period of the change. Instead, financial information for the pre-change interim periods of the fiscal year in which the change is made shall be stated by applying the newly adopted accounting principle to those prechance interim periods. The cumulative effect of the change on retained earnings at the beginning of that fiscal year shall be included in restated net income of the first interim period of the fiscal year in which the change is made.
2.7 Disclosure of Summarized Interim Financial Data
In order to be timely, interim financial reports may not be as detail as annual financial reports. However they should contain at minimum the following information: for the current quarter, the current year-to date, or the last 12 months to date.
- Sales (or gross revenue),
- Provision for income taxes
- Extra ordinary items
- Cumulative effect of change in accounting principles
- Net income
- Earning per share data
- Seasonal revenue, costs, or expenses
- Significant changes in estimates or provision for income taxes
- Disposal of a business segment
- Contingent items
- Significant changes in financial position
Note that interim reports may not be prepared for the 4th quarter of the fiscal year. In such case, annual financial reports should disclose the effects of the following for the fourth quarter:
- Disposal of a segment
- Extraordinary items
- Changes in accounting principles
- The aggregate effect of year-end adjustments that are material to the 4th quarter results.
Annual financial statements normally do not provide decision makers with the timely data needed to make decisions. Thus, external decision makers need financial data for shorter intervals of time. Interim financial statements are provided to external users to meet their needs.
Interim financial statements may be prepared using the discrete period approach, and integral period approach. The integral period approach is presently used for interim reporting purposes.
Revenues in interim reports are recognized on the same basis used for annual reports. Costs and expenses that are associated with revenue are allocated to the products or service rendered. Another costs and expenses are charged to the interim period based on time expired, benefits received, or activities associated with the interim period.
The income tax provision for an interim period should use an effective annualized tax rate. Extraordinary and other non-operating items should be recognized in the interim period in which they occur.