a. Cash xxxGain on disposition* xxxNet assets of discontinued operations xxx * (A loss on disposition would be recorded as a debit)b. Income (expense) related to discontinued operations include theoperating profit (loss) recorded prior to sale and the gain (loss) on sale.These are reported net of applicable tax.c. When estimating future earning power, the results from discontinuedoperations should not be treated as recurring. This is important for an assessment of the permanent income of a company.d. Separately reporting discontinued operations allows the analyst to viewthe results of operations without the segment that will not be ongoing.As a result, the analyst can better assess the permanent component of income, for which results of discontinuing operations will be excluded. Exercise 6-2 (30 minutes)a. By the use of reserves, a company can allocate costs in excess ofactual experience in the current period, based on estimates of additional costs in the future, or even based on the simple possibility of further costs in the future. Then, in later periods, actual costs can be written off against the reserve rather than reported as expenses in the company's income statement for those periods. The advantage to the company is that earnings trends can be "smoothed," and a cushion for future earnings can be built up during good economic years for use during leaner periods. To the extent that stability and predictability of earnings are market virtues, the company's common stock might be accorded a higher multiple for these efforts, in effect lowering the cost of capital to the company. The use of reserves both poses problems for the analyst and conflicts with some basic accounting principles. These include:(1) Use of reserves contradicts the matching principle, by whichrevenues and related costs should be recognized in the same period.(2) Reserving for future events (especially contingencies) is obviouslysubject to estimate, and accounting should attempt to record quantifiable value as much as possible.(2) The reserving technique makes reported earnings less indicative offundamental trends in the company. The effects of the economiccycle are reduced, making correlation techniques (such as GNPgrowth vs. EPS growth) invalid. These reported numbers mightmislead the “uninformed” investor. In contrast to the artifici alsmoothing referred to earlier, the company's growth rate may beexaggerated, by over-reserving for losses in a bad year, andsubsequent writing off of the reserve.It should be noted that a reserve can be properly taken such as when itrecognizes a liability that (1) likely exists in the relatively near future—such as costs of winding up a plant shutdown with the next year or (2)is subject to quantification—such as the outright expropriation of netassets in a foreign country.b. If the analyst is able to discern the impact of reserves, s/he shouldexclude the reserves' impact from accounting income when assessingpast trends. Only operating or normal earnings should be comparedover the short-term. However, over a longer period of time, the lossesagainst which reserves have been taken should be included. Inestimating future earnings, the analyst must carefully consider theimpact of reserves and exclude the impact when forecasting normalearnings. By doing this, the analyst will have a better understanding ofthe true operations of the company. In the valuation of common stock,the analyst must focus on the sustainable earning power of thecompany. Thus, earnings may have to be adjusted upward or downwarddepending on the degree of abuse of reserves.c. Several examples of reserves are cited in the chapter. Also, studentsoften benefit from a review of business magazines in attempting toidentify such reserves.(CFA Adapted) Exercise 6-3 (35 minutes)a. A change from the sum-of-the-years'-digits method of depreciation tothe straight-line method for previously recorded assets is a change inaccounting principle. Both the sum-of-the-years'-digits method and thestraight-line method are generally accepted. A change in accountingprinciple results from adoption of a generally accepted accountingprinciple different from the generally accepted accounting principleused previously for reporting purposes.b. A change in the expected service life of an asset arising because ofmore experience with the asset is a change in accounting estimate. A change in accounting estimate occurs because future events and their effects cannot be perceived with certainty. Estimates are an inherent part of the accounting process. Therefore, accounting and reporting for certain financial statement elements requires the exercise of judgment, subject to revision based on experience.c. 1. The cumulative effect of a change in accounting principle is thedifference between: (1) the amount of retained earnings at the beginning of the period of change and (2) the amount of retained earnings that would have been reported at that date if the new accounting principle had been used in prior periods.2. FASB 2005 Statement “Accounting Changes and Error Corrections”requires that effective in 2005, companies should apply the “retrospective approach” to changes in accounting principle. Thus, all presented periods must be restated as if the change were in effect during those periods, and any cumulative effect from periods before those presented is an adjustment to beginning retained earnings of the earliest period presented.d. Consistent use of accounting principles from one accounting period toanother enhances the usefulness of financial statements in comparative analysis of accounting data across time.e. If a change in accounting principle occurs, the nature and effect of achange in accounting principle should be disclosed to avoid misleading financial statement users. There is a presumption that an accounting principle, once adopted, should not be changed in accounting for events and transactions of a similar type.f. Mandatory accounting changes are largely non-discretionary. Thus,managerial discretion is not present, or at least is to a lesser degree.One should examine the motivations for voluntary accounting changes and assess any earnings quality impact.g. Mandatory accounting changes are largely non-discretionary. However,there is often a window of time for a company to adopt a mandatory accounting change. If a window exists, management has discretion as to the timing of the adoption. Thus, the timing of adoption and any accounting ramifications should be considered. For example, if a manager is going to adopt an accounting change that includes a large charge, the manager might choose to adopt in a relatively poor quarterto attempt to potentially conceal or downplay the poor operating performance.h. Mandatory accounting changes often include the recognition ofretroactive earnings affects. For example, the rules in accounting for other post-employment benefits require that companies establish a liability for the accrued benefits to date. This results in a large charge for many companies. Of course, the market potentially views the charge as largely the fault of accounting rule makers. Thus, managers have incentive to increase the amount of the charge and use the bloated liability to increase future earnings.。