The term “interim reporting” refers to financial reporting for periods of less than a year. GAAP itself does not mandate interim reporting; however, the SEC requires public companies to file quarterly condensed financial information on Form 10-Q. The information required in those interim reports is substantially less than is specified under GAAP for annual financial statements, but the extent of informational content in interim financial statements is an evolving matter.
Interim reporting is problematic for reasons other than the choice of an underlying measurement philosophy. As reporting periods are shortened, the effects of errors in estimation and allocation are magnified, and randomly occurring events which might not be material in the context of a full fiscal year could create major distortions in short interim period summaries of reporting entity performance. The effects of seasonal fluctuations and temporary market conditions further limit the reliability, comparability, and predictive value of interim reports.
Furthermore, the seemingly insatiable demand for information (particularly when in the consumers’ view such information is available free of charge) is also changing how and how soon interim data is to be reported, and what level of assurance is to be provided by both preparers and independent attesting entities. With the advent of modernized accounting procedures such as the “virtual close,” users will in the not-too-distant future be demanding to receive information from reporting entities on a real-time basis.
This post answers the most frequent questions regarding interim reporting. This guideline is by no meant perfect, more comprehensive research and study is absolutely required. Enjoy!
1. What Is the Basic Objective of Interim Reporting?
The basic objective of interim reporting is to provide current information regarding enterprise performance to existing and prospective investors, lenders, and other financial statement users. This enables these users to act upon relevant information in making informed decisions in a timely manner. The demand for timely information (e.g., SEC filings on Form 10-Q are due in no greater than 45 days after period end, whereas filings on Form 10-K are due, depending on entity size, as long as 90 days after year-end) means that interim data will often be more heavily impacted by estimates and assumptions.
2. Historically, What Have Been Competing Views Of Interim Reporting?
- Under the integral view, the interim period is considered to be an integral part of the annual accounting period. It thus follows that annual operating expenses are to be estimated and then allocated to the interim periods based on forecasted annual activity levels such as sales volume. The results of subsequent interim periods must be adjusted to reflect the effect of estimation errors in earlier interim periods of the same fiscal year. The APB indicated a preference for the integral view in APB 28, which remains the principal guidance on this topic.
- Under the discrete view, the interim period is considered to be a discrete accounting period. Thus, estimations and allocations are to be made using the same methods used for annual reporting. It follows that the same expense recognition rules apply as under annual reporting, and no special interim accruals or deferrals would be necessary or permissible. Annual operating expenses are to be recognized in the interim period incurred, irrespective of the number of interim periods benefited (i.e., there would be no special deferral rules for interim periods).
3. What Are the Proponents of the Integral and Discrete Views?
- Proponents of the integral view argue that unique interim expense recognition procedures are necessary to avoid fluctuations in period-to-period results that might be misleading to financial statement users. Using the integral view results in interim earnings which are indicative of annual earnings and, thus, arguably more useful for predictive purposes.
- Proponents of the discrete view argue that the smoothing of interim results for purposes of forecasting annual earnings has undesirable effects. For example, a turning point during the year in an earnings trend could be obscured if smoothing techniques implied by the integral view approach were to be employed.
4. What Are Some Guidelines In Preparing Interim Reports?
- Interim results should be based on the accounting principles used in the last year’s annual report unless a change has been made in the current year.
- A gain or loss cannot be deferred to a later interim period unless such deferral has been permissible for annual reporting.
- Revenue from merchandise sold and services performed should be accounted for as earned in the interim period in the same way as accounted for in annual reporting. If an advance is received in the first quarter and benefits the entire year, it should be allocated ratably to the interim periods affected.
- Costs and expenses should be matched to related revenue in the interim period. If a cost cannot be associated with revenue in a future interim period, it should be expensed in the current period. Yearly expenses such as administrative salaries, insurance, pension plan expense, and year-end bonuses should be allocated to the quarters. The allocation basis may be based on such factors as time expired, benefit obtained, and activity.
- The gross profit method can be used to estimate interim inventory and cost of sales. Disclosure should be made of the method, assumptions made, and material adjustments by reconciliations with the annual physical inventory.
- A permanent inventory loss should be reflected in the interim period during which it occurs. A subsequent recovery is treated as a gain in the later interim period. However, if the change in inventory value is temporary, no recognition is given in the accounts.
- When there is a temporary liquidation of the LIFO base with replacement expected by year-end, cost of sales should be based on replacement cost.
- When a standard cost system is used, variances expected to be reversed by year-end may be deferred to an asset or liability account.
The historical cost of an inventory item is $10,000 with replacement cost expected at $15,000. The entry is:
[Debit]. Cost of Sales = $15,000
[Credit]. Inventory =$10,000
[Credit]. Reserve for Liquidation of LIFO Base = $5,000
The Reserve for Liquidation of LIFO Base account is shown as a current liability. When replenishment is made at year-end the entry is:
[Debit]. Reserve for Liquidation of LIFO Base = $5,000
[Debit]. Inventory = $10,000
[Credit]. Cash = $15,000
Volume discounts given to customers tied into annual purchases should be apportioned to the interim period based on the ratio of:
Purchases for the interim period / Total estimated purchases for the year
5. How Often Should Interim Reports Be Given?
Interim reports may be issued at appropriate reporting intervals, for example, quarterly or monthly. Complete financial statements or summarized data may be given, but interim financial statements do not have to be certified.
6. What Type Of Report Is Appropriate For An Interim Period?
Interim balance sheets and cash flow data should be provided. If these statements are not presented, material changes in liquid assets, cash, long-term debt, and stockholders’ equity should be disclosed. Interim reports usually include results of the current interim period and the cumulative year-to-date figures. Typically, comparisons are made to results of comparable interim periods for the prior year.
7. How Are Taxes Reflected In Interim Reports?
The income tax provision includes current and deferred taxes, both federal and local. The tax provision for an interim period should be cumulative.
Total tax expense for a nine-month period is shown in the third quarter based on nine-month income. The tax expense for the three-month period based on three months’ income may also be presented. For example: Third quarter tax expense based on only the third quarter.
8. What Tax Rate Do I Use?
In computing tax expense, the estimated annual effective tax rate should be used. The effective tax rate should be based on income from continuing operations. If a reliable estimate is not practical, the actual year-to-date effective tax rate should be used.
The estimated effective tax rate should incorporate:
- All available tax credits (e.g., foreign tax credit)
- All available alternative tax methods in determining ordinary earnings
A change in tax legislation is only reflected in the interim period affected
At the end of each interim period, a revision to the effective tax rate may be necessary, employing the best current estimates of the annual effective tax rate. The projected tax rate includes adjustment for net deferred credits. Adjustments should be contained in deriving the maximum tax benefit for year-to-date figures.
9. How Are Income And Losses Accounted For On Interim Reports?
Income statement items after income from continuing operations (e.g., income from discontinued operations, extraordinary items, cumulative effect of a change in accounting principle) should be presented net of the tax effect. The tax effect on these unusual line items should be reflected only in the interim period when they actually occur.
Do not predict items before they occur. Prior period adjustments in the retained earnings statement are also shown net of tax when they take place.
10. What Do I Do About A Change In Principle?
When a change in principle is made in the first interim period, the cumulative effect of a change in principle account should be shown net of tax in the first interim period. If a change in principle is made in a quarter other than the first (e.g., third quarter), we assume the change was made at the beginning of the first quarter showing the cumulative effect in the first quarter. The interim periods will have to be restated using the new principle (e.g., first, second, and third quarters). When interim data for previous years are presented for comparative purposes, data should be restated to conform with newly adopted policies. Alternatively, disclosure can be made of the effect on prior data, if the new practice had been applied to that period.
For a change in principle, disclosure should be made of the nature and justification in the interim period of change. The effect of the change on per share amounts should be given.
11. What Other Factors Affect Interim Results?
- Disclosure should be made of seasonality aspects affecting interim results and contingencies.
- A change in the estimated effective tax rate should be disclosed.
- If a fourth quarter is not presented, any material adjustments to that quarter must be commented upon in the footnotes to the annual report.
- If an event is immaterial on an annual basis but material in the interim period, it should be disclosed.
- Purchase transactions should be noted.
12. How Do I Present Prior Period Adjustments?
The financial statement presentation for prior period adjustments:
- Net income for the current period should include the portion of the effect related to current operations.
- Earnings of impacted prior interim periods of the current year should be restated to include the portion related thereto.
- If the prior period adjustment affects prior years, it should be included in the earnings of the first interim period of the current year.
Criteria to be met for prior period adjustments in interim periods:
- Identified to a prior interim period
Prior period adjustments for interim reporting include:
- Error corrections
- Settlement of litigation or claims
- Adjustment of income taxes
- Renegotiation proceedings
- Utility revenue under rate-making processes
Earnings per share is computed for interim purposes the same way as for annual purposes. Segmental disposal is shown separately in the interim period during which it occurs.