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FIN Chapter 4 - The Income Statement and the Statement of...

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Unformatted text preview: The Income Statement and the Statement of Cash Flows Income Statement Displays a company’s operating performance, Displays that is, its net profit or loss, during the reporting period. period. Reports changes in shareholders’ equity that Reports occurs during a period occurs Useful for predicting future profitability (future Useful cash-generating ability) cash-generating 3 Statement of Cash Flows Provides information about the cash Provides receipts and cash disbursements of an enterprise that occurred during a period. enterprise Reports change in cash that occurs Reports during a period during Provides information about operating, Provides investing and financing activities investing The Income Statement Example in Graphic 1-4, p. 167 should be Example template. template. Apple’s Income Statement Income Statement Components Includes the revenues, expenses, gains and Includes losses that will probably continue in future periods periods Revenues are inflows of resources resulting Revenues from providing goods or services to customers. from Expenses are outflows of resources incurred Expenses while generating revenue. while Gains and Losses are increases and decreases Gains in equity from peripheral or incidental transactions. transactions. – Do not result directly from operations Expenses If causality can be determined between If revenues and expenses, then expenses are reported in the same period that the related revenue is recognized. related If causality can’t be established, then If choices are: choices – Relate expense to a particular period – Allocate expense over several periods – Expense as incurred Income Tax Expense Must be shown as separate expense on Must the income statement. the Tax rules differ from GAAP as far as Tax timing of recognition for revenues and expenses. expenses. – This means that tax expense on the income This statement will differ from cash paid for taxes. statement – Result is deferred tax assets and liabilities. Operating versus Nonoperating Income Operating income includes revenues and Operating expenses directly related to the principal revenue-generating activities of the company. revenue-generating Nonoperating income includes gains and losses Nonoperating and revenues and expenses related to peripheral or incidental activities of the company. peripheral – Referred to as “other” revenue and expense – Examples: investments, sale of assets, interest and Examples: dividend revenue, interest expense. dividend Income Statement Formats Single-Step income statement format groups all Single-Step revenues and gains together and all expenses and losses together. and – Advantage: Simplicity Multiple-Step income statement includes a Multiple-Step number of intermediate subtotals before arriving at income from continuing operations. at – Advantage: More useful for identifying trends – This method is required from this point on. Earnings Quality Earnings quality refers to the ability of Earnings reported earnings (income) to predict a company’s future earnings. company’s Predictive value is enhanced if can Predictive separate out transitory earnings from permanent earnings. permanent Manipulating Income and Income Smoothing Within GAAP, managers have much discretion. – Intended to allow for differences in operating models while Intended achieving representational faithfulness. achieving Managerial incentives interact with the latitude afforded Managerial by GAAP by – Income increasing – motivated by EPS targets, bonuses, stock Income compensation, job retention compensation, – Income decreasing – “big bath”, outperformance, manage future Income expectations expectations – Income shifting – achieved by accelerating or delaying the Income recognition of revenues and expenses recognition – Income statement classification – including recurring operating Income expenses in “special items” or restructuring costs which makes them appear more transitory than they are. them Two techniques for income manipulation: Restructuring Costs Include costs associated with shutdown or Include relocation of facilities or downsizing of operations. operations. Requires estimating future costs and recording Requires an expense and liability – achieves matching because expense is in period that restructuring decision was made (prior to 2003). decision – However, if managers overestimated amount of However, expense, they could reverse restructuring costs which gave the appearance of “income” in future periods. gave SFAS 146 (2002) now requires that restructuring SFAS costs be recognized only in the period incurred. costs Nonoperating Income and Earnings Quality Gains and losses from the sale of Gains operational assets and liabilities can significantly inflate or deflate current earnings. earnings. Pro Forma Earnings Companies voluntarily provide pro forma Companies earnings – management’s assessment of permanent earnings. permanent – Often excludes stock-based compensation, Often restructuring and impairment charges, intangible amortization, gains and losses from sale of investments, litigation costs sale Sarbanes Oxley requires a reconciliation Sarbanes between pro forma earnings and GAAP earnings. earnings. Separately Reported Items GAAP requires that certain transactions be GAAP reported separately in the income statement, below income from continuing operations below – Discontinued Operations – Extraordinary Items Must be reported net of tax Cumulative Effect of a Change in Accounting Cumulative Principle – also included for periods before 2005. 2005. – Entire effect used to be reported in year of change. – Now we must retroactively recast prior years’ financial Now statements (those presented in comparative analysis) statements Intraperiod Income Tax Allocation Separately reported items occur below income from Separately continuing operations (which has already had income tax expense deducted from it) – see p. 167. expense – Allows better forecasting of recurring after-tax income Means separately reported items have income tax Means expense computed separately for each item. expense – Discontinued operations and extraordinary items must be shown Discontinued net of their related income tax effect. net – Must disclose on the face of the income statement the amount of Must tax associated with the item tax Sum of tax and net of tax amounts equal the before tax Sum gain or loss gain – Gains require additional taxes to be paid. – Losses decrease the overall tax expense (provide a tax Losses “benefit”) “benefit”) E4­4, p. 207 Work in class Discontinued Operations When a company disposes of part of their When business business What Constitutes an Operation? SFAS 144 – a component of an entity comprises SFAS operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. purposes, Two conditions must be met: – The operations and cash flows of the component have been (or The will be) eliminated from the ongoing operations. will – The entity will not have any significant continuing involvement in The the operations of the component after the disposal transaction. the More disposals qualify for discontinued operations under More U.S. GAAP than under IFRS (No. 5) where the operations must be either a major line of business or geographical segment. geographical Reporting Discontinued Operations The revenues, expenses, gains, losses, The and income tax expense related to the discontinued operations need to be removed from continuing operations. removed Must also consider the disposal of the Must discontinued component itself. discontinued Reporting Discontinued Operations When the component has been sold before the end of When the reporting period, discontinued operations will be made up of two parts: made – Operating income or loss (revenues, expenses, gains, and Operating losses) of the component from the beginning of the reporting period to the disposal date – Gain or loss on the disposal of the component’s assets Gain Two elements can be combined or reported separately, Two net of their tax effects. net Must remove income or loss from discontinued Must operations for any prior periods presented (comparative income statements). income Reporting Discontinued Operations When the component is considered held for sale at the end of the When reporting period and is likely to be sold within one year, then discontinued operations includes: discontinued – Operating income or loss (revenues, expenses, gains, and losses) of Operating the component from the beginning of the reporting period to the end of the reporting period – An impairment loss if the carrying value of the assets of the component An is greater than the fair value of the asset less their selling costs is Two elements can be combined or reported separately, net of their Two tax effects. tax The component assets are reported at their lower (impaired) value The on the balance sheet and: on Component assets are reclassified from PPE to Investments (held Component for sale) for – They are no longer depreciated or amortized Reporting Discontinued Operations Disclosure: – Must disclosure effect of impairment either Must parenthetically or in the footnotes. parenthetically – Additional disclosure would include the Additional identity of the discontinued component, the major classes of assets and liabilities of the component, the reason for discontinuance, and the expected manner of disposition. and E4­7, p. 208 Work in class Extraordinary Items Material gains and losses that are both unusual Material both and infrequent in occurrence. and Examples of extraordinary items: – Natural disasters in places where these disasters are Natural rare, expropriation of assets rare, – Loss of major customer, death of executive, strikes, Loss September 11th, Hurricane Katrina September The following are NOT considered extraordinary: The NOT Extraordinary items are presented net of tax Could soon be eliminated in effort to converge Could with IFRS. with Unusual or Infrequent Items If unusual OR infrequent, but not both, and If amount is material, then income effect of that event should be reported as a separate component of continuing operations (NOT net of tax). operations – Examples: restructuring costs, goodwill or Examples: long-lived asset impairments long-lived Accounting Changes Three categories: – Change in Accounting Principle – Change in Estimate – Change in Reporting Entity Change in Accounting Principle A change from one acceptable accounting change method to another. method Can be either voluntary (i.e., inventory Can valuation method changes, revenue recognition changes) or mandated by a new accounting standard new Voluntary Changes in Accounting Principles Creates inconsistency in data Accounted for retrospectively by revising prior Accounted years’ financial statements (SFAS 154) years’ – Prior to FAS154, the cumulative effect on the income Prior of previous years from having used the old method rather than the new method was included in the income statement as a separately reported item (like discontinued operations and extraordinary items) in the year of change. the – Now we retrospectively recast prior years’ F/S in Now comparative presentations as if the new method had been used all along. been Voluntary Changes in Accounting Principles A jjournal entry is needed to adjust all account ournal balances affected by the change balances An adjustment is shown to beginning retained An earnings of the earliest period presented to account for the cumulative income effect of changing to the new principle in years prior to those that are reported in the F/S. those Footnote disclosure must explain why the Footnote change is justified along with disclosing the effects of the change on items not disclosed on the face of the F/S, we well as any per share amounts affected for all periods presented. amounts Mandated Changes in Accounting Principles Several options depending on standard: – Change retrospectively (as in voluntary Change changes) changes) – Allow companies to report the cumulative Allow effect (as a separately reported item, net of tax) on the income of previous years from using the old method rather than the new method in the year of change (pre-FAS 154) method Change in Depreciation, Amortization or Depletion Method Changes in depreciation, amortization, or Changes depletion methods are accounted for the same way as a change in estimate. same – Used to be a change in accounting principle Used prior to FAS 154. prior Change in Accounting Estimate Reflected in F/S in current period prospectively – Reflected do not revise prior years’ F/S to reflect new estimate. estimate. Do not require the company to justify the change Do in the disclosures unless changing depreciation, amortization, or depletion methods (in which case justification, effect on net income and earnings per share is still needed even though the change is made prospectively). the E4­9, p. 208 Work in class Change in Reporting Entity Can be due to change in accounting rules (i.e., consolidation of Can related entities) or due to acquisition or merger. related – If due to change in accounting rules, SFAS 154 requires that the prior If period F/S presented comparatively be restated as if the new entity existed in all periods presented. existed – If due to acquisition/merger, the acquirer’s pre-merger F/S are not If restated. restated. – Results in problems of consistency for firms that undergo a structural Results change. change. Acquiring companies must disclose acquisition details in footnotes Acquiring and present key F/S information on pro forma basis (as if acquisition had happened at beginning of all periods presented). had – Pro forma information must include revenue, income before Pro extraordinary items, net income, and earnings per share. extraordinary Correction of Accounting Errors Errors: recording incorrectly or omitting Errors: entirely entirely – If error detected in the same year it was If made, then correct with journal entry. made, – If error detected in subsequent year, if not If material, then correct with journal entry. material, – If error is material, then prior period If adjustment is needed. adjustment Prior Period Adjustments Adjusts beginning retained earnings for Adjusts income effect of error in Statement of Stockholders’ Equity (or Statement of Retained Earnings). Retained Retrospectively restate any erroneous Retrospectively prior years’ F/S that are presented for comparison. comparison. Footnote disclosure required to Footnote communicate impact of error on income. communicate Earnings Per Share Disclosures All publicly-traded companies must All disclose EPS Net income of a company disclosed on a Net per share basis per Allows for comparison of different-sized Allows companies companies Need to disclose basic and diluted EPS Earnings Per Share Disclosures Basic EPS = Net income less preferred Basic dividends/Weighted-Average Number of Common Shares Outstanding Common Must also report all items “at the line” (income Must from continuing operations) and below (all the way down to net income) on a per share basis way – Subtotals: Subtotal less preferred dividends/ Subtotals: Weighted-Average Number of Common Shares Outstanding Outstanding – Individual adjustments (gains or losses): Gain or loss/ Individual Weighted-Average Number of Common Shares Outstanding Outstanding Earnings Per Share Disclosures Diluted EPS reflects potential dilution that Diluted could occur if convertible debt is converted or stock options are exercised. or Dilution increases the denominator so that Dilution Basic EPS > Diluted EPS (for profitable firms) firms) Apple’s EPS Apple’s EPS Comprehensive Income Comprehensive Income = Net Income Comprehensive plus Other Comprehensive Income plus Comprehensive Income is the total Comprehensive change in equity for a reporting period other than from transactions with owners other Apple’s Comprehensive Income Other Comprehensive Income Gains and losses that change shareholders’ equity but Gains that bypass the income statement that “Clean Surplus” relates to the concept that all changes in Clean equity flow through the income statement. equity Other comprehensive income items are sometimes Other referred to as “dirty surplus” items. referred – Examples: gains and losses from certain types of investments Examples: (available for sale), certain derivative gains and losses, some foreign currency adjustments. foreign – These items are usually found on the Statement of Stockholders’ These Equity (alternatively can be shown at bottom of income statement) statement) – They change the equity balances, but not via net income. Accumulated Other Comprehensive Income Cumulative total of other comprehensive Cumulative income (or loss) is reported as an additional component of shareholders’ equity (as a separate line item) equity The Statement of Cash Flows Provides information about the cash Provides receipts and cash disbursements of an enterprise that occurring during a period (a change statement). change Cash refers to cash plus cash equivalents. Usefulness of the Statement of Cash Flows The only sustainable source of financing The are internally-generated funds (cash flows from operations). from Converts accrual-based income statement Converts into cash-based statement. into Classifying Cash Flows Operating – inflows and outflows of cash Operating related to the transactions related to net operating income operating Investing Financing General Format: Cash provided by (or used in): Operating activities Investing activities Financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year $XXXX XXXX XXXX XXXX $XXXX XXXX XXXX $XXXX Operating Activities Cash inflows: – Cash received from customers from the sale of goods or Cash services services – Cash received from interest and dividends from investments (is Cash this really operating from a theoretical standpoint)? this Cash outflows: – – – Cash paid to suppliers for the purchase of inventory Cash paid for salaries, wages, and other operating expenses Cash paid for interest on debt (is this really operating from a Cash theoretical standpoint)? theoretical – Cash paid for income taxes Operating Activities Difference between inflows and outflows is Difference called net cash from operating activities called IFRS allows companies to choose IFRS between operating and investing for interest received and dividends received. Also allows companies to choose between operating and financing for interest paid and for dividends paid (must be financing for U.S. GAAP). for Direct and Indirect Methods of Reporting Direct method – provides more information but Direct more difficult to prepare more Indirect method – uses accrual net income as Indirect starting point and makes adjustments as necessary. necessary. Both methods result in same number for net Both cash flows from operating activities cash Investing and financing sections are identical for Investing both direct and indirect method. both Direct Method Sales and Cash Collected from Customers: Beginning A/R + Sales = Cash available for collection - Ending A/R = Cash collected from customers Direct Method Cost of Goods Sold and Cash Paid for Inventory: Ending inventory + Cost of goods sold = Required inventory - Beginning inventory = Inventory purchased this year *** Common mistake: Students report this number Are we done? NO! Beginning A/P + Inventory purchased this year = Cash required to be paid - Ending A/P = Cash paid for inventory Direct Method Wages expense and cash paid for wages: Beginning wages payable + Wages expense = Total obligation to employees - Ending wages payable = Cash paid for wages Indirect Method Net Income + Depreciation, amortization, depletion + Losses - Gains +/- Box that Rocks stuff Cash Flow From Operations Box that Rocks Current Asset Increase Decrease Subtract Current Liability Add Add Subtract Investing Activities Investing cash inflows include: – Sale of long-term assets used in the business – Sale of investment securities other than cash equivalents Sale (current and noncurrent) (current – Collection of loans or non-trade receivables (excluding interest Collection which is operating activity) which Investing cash outflows include: – Purchase of long-term assets used in the business – Purchase of investment securities other than cash equivalents Purchase (current and noncurrent) (current – Money loaned to other parties. Net cash flows from investing equals investing cash Net inflows less investing cash outflows inflows Financing Activities Financing cash inflows include: – Proceeds from sale of company’s own stock – Proceeds from loans taken out (notes, loans, Proceeds mortgages, bonds) mortgages, – Cash paid for dividends Cash – Cash paid to repurchase own company’s stock (share Cash repurchases) repurchases) – Repayments of principal on loans (interest paid is an Repayments operating activity) operating Financing cash outflows include: Net cash flows from financing equals financing Net cash inflows less financing cash outflows cash Noncash Investing and Financing Activities All cash flow statement amounts are All based on cash exchanged. based However, there may be material However, transactions that do not involve cash. transactions Must be reported either on the face of the Must Statement of Cash Flows or in a footnote disclosure. disclosure. Apple’s Statement of Cash Flows Cash Flow Patterns Normal pattern of cash flows is: – Cash from operating activities (+) – Cash from investing activities (-) – Cash from financing activities (+ or -) Over 70% of U.S. companies generate positive cash Over flows from operations flows Several periods of negative cash flows is a sure indicator Several of financial trouble of Over 85% of U.S. companies generate negative cash Over flows from investing (otherwise liquidating assets) flows Younger companies will have positive cash flows from Younger financing, while more mature companies will have negative cash flows from financing negative Example ­ Handout Problem from Handout ...
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