FINANCIAL ACCOUNTING - PowerPoint Presentation

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FINANCIAL ACCOUNTING

RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY

THEORY AND ANALYSIS: TEXT AND CASES11TH EDITIONSlide2

CHAPTER 6

Financial Statements I:

The Income StatementSlide3

Introduction

Various groups are affected by, and have a stake in, the financial reporting requirements of the FASB and the SECSlide4

Introduction

Investors in equity securities are the central focus of the financial reporting environmentSlide5

Introduction

Investing involves

Giving up current resources

For

future uncertain resources.

Therefore, investors require information assessing future cash flows.Slide6

The Economic Consequences of Financial Reporting

Financial reporting has economic consequences including:

Financial information can affect the distribution of wealth among investors. More informed investors, or investors employing security analysts, may be able to increase their wealth at the expense of less informed investors.Slide7

The Economic Consequences of Financial Reporting

Financial information can affect the level of risk accepted by a firm.

Focusing on short-term, less risky, projects may have long-term detrimental effects.

Financial information

Can

affect the rate of capital formation in the economy

And

result in a reallocation of wealth between consumption and investment within the economy.Slide8

The Economic Consequences of Financial Reporting

Financial information can affect how investment is allocated among firms.

These economic consequences may have a differential impact on different user groups and future deliberations of standards must consider these economic consequencesSlide9

Income Statement Elements

SFAC No. 8 indicates that the primary

focus of financial reporting is to provide information about a company’s performanceSlide10

Income Statement Elements

Vehicle for relaying performance assessments to investors

SFAC No. 6: defined the elements of the income statement

Revenues

Gains

Expenses

LossesSlide11

Each Term Is Defined As Changes in Assets and Liabilities

Differences between changes in assets approach and inflow and outflow definition are:

Change in net economic resources

1.

VS

Views as a measure of effectiveness

Definition of Assets and Liabilities

2.

VS

Definition of Revenue & Expenses

Defining Earnings

Created as a result of measuring income

3.

VS

Recognized only when they are economic resources or obligations

Determining Earnings

Creating deferred chargesSlide12

Each Term Is Defined As Changes in Assets and Liabilities

4.

Both agree on importance of income statement

Net economic resources and to the transactions

and events that change measurable attributes of those net resources

5.

VS

Items necessary to match revenues and costs

Population from which the elements of financial statements can be selectedSlide13

Statement Format

The preparation of the income statement has been impacted by differences of opinion on the definition of ongoing operations.

Two views:

All inclusive

Current operating performanceSlide14

= Net income

= Income from continuing operations

Discontinued operations Extraordinary items Change in accounting principle= Gross profit Less: Administrative and selling expenses

Plus: Other gains

Less: Other losses

Current Income Statement Format

Proscribed in APB Opinion No. 9 as:

Revenues

Less: Cost of goods sold

Excludes prior-period adjustmentsSlide15

Income From Continuing Operations

Normal and recurring revenues and expensesSustainable incomeIncome tax (recurring items)Nonrecurring items (Each net of their tax effect)

Discontinued operationsExtraordinary itemsChange in accounting principleSlide16

Tootsie Roll and Hershey

Tootsie Roll Industries and The Hershey Company are internationally known candy manufacturers.

We will use information from the two companies’ fiscal 2007 - 2011 annual reports to illustrate the disclosure of information in this and subsequent chapters. Slide17

Discontinued Operations

Why special treatment?

Arise from a disposal of a component of a businessComprising operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity.

Original criteria contained in APB Opinion No. 30.

This release required the separate presentation of (1) the results of operations of the disposed segment, and (2) gain or loss on the sale of assets for disposed segments including any operating gains or losses during the disposal period.

Time of disclosure was determined by whether a gain or loss was expected on the measurement date

Amended by SFAS 144Slide18

SFAS No. 144 FASB ASC 360

Changed reporting of discontinued operations:Unit must qualify as a component (distinguishable assets and cash flowsIf so:Operations and cash flows of component must be eliminated as a result of the transaction

Company does not retain any significant involvement in operations of component after disposal Neither Hershey or Tootsie Roll disclosed any discontinued operationsSlide19

Accounting for Discontinued Operations Under Continuing Review

FASB Exposure DraftSeptember 2008Amending the Criteria for Reporting a Discontinued OperationIASB Exposure Draft

Discontinued OperationsDefinitions in SFAS No. 144 and IFRS No. 5 not convergentProposed definition:An operating segment that has been disclosed of or is up for sale; orA business that meets the criteria to be classified as held for sale on acquisition.Slide20

Discontinued Operations FAS 2013-46

Subsequent to the publication of this text, the FASB issued a FAS 2013-46 which changed the criteria for determining disposals to be presented as discontinued operations. The new definition of a discontinued operation is a component or group of components that has been disposed of or is classified as held for sale, together as a group in a single transaction, and represents a strategic shift that has (or will have) a major effect on an entity's financial results.

A business that, upon acquisition, qualifies as held for sale will also be a discontinued operation.Entities are required to disclose the operating and investing cash flows for discontinued operations. For disposals of individually material components that do not qualify as discontinued operations, the board decided to require disclosures of pre-tax profit or loss of the disposed component and the amount attributable to the parent if there is a noncontrolling interest. Public entities will be required to apply the guidance in annual periods beginning on or after December 15, 2014, and interim periods within those annual periods. Nonpublic entities will be required to apply the guidance within annual periods beginning on or after December 15, 2014, and interim periods thereafter.Slide21

Extraordinary Items

Original definition APB No. 9 – not expected to recur

Problems – similar items not being classified similarly

APB Opinion No. 30Unusual nature

Infrequency of occurrence

Problem:

Requirements do not always separate recurring and non-recurring items – unusual but not infrequent

As a result, there is a tendency to increase the variability of operating income and decrease the predictive ability of earnings

The events of 9/11

Neither company discloses any extraordinary items for the years presentedSlide22

Accounting Changes

The accounting standard of consistency requires that similar transactions should be reported similarly each year

Occasionally an entity may find that reporting needs are better served by changing a method of accounting

If so, the comparability of financial statements is impairedBasic question: Should previously issued financial statements be amended?Slide23

Accounting Changes

APB Opinion No. 20 originally identified four types of accounting changes: Change in an accounting principle

Occurs when an entity adopts a GAAP that differs from one previously used for reporting purposes. Change in an accounting estimate Result from the necessary consequences of periodic presentation. Change in a reporting entity Caused by changes in reporting units, which may be the resultConsolidations, Changes in specific subsidiaries, or a Change in the number of companies consolidated.

Errors Not viewed as accounting changes.

Result of mistakes or oversights such as the use of incorrect accounting methods or mathematical miscalculations.Slide24

Types of Accounting Changes

Change in accounting principle

How reportedAPB Opinion No 20 – Catch-up adjustment with 3 exceptionsSFAS No 154 – Retrospective application

Change in accounting estimate

How reported

– Prospective application

Change in accounting entity

How reported- Retrospective application

Errors

How reported –Prior period adjustments Slide25

Earnings Per Share

Basic calculation

APB No. 9 – concept of residual and senior securities

APB No. 15

Simple vs. complex capital structure

Required calculation of primary and fully diluted earnings per share

The concept of common stock

equivalents

Criticism of APB No. 15 - arbitrary, complex and illogical

The FASB and IASC project

Net income - Preferred dividends

Average # of common shares outstandingSlide26

SFAS No. 128

Reasons for the change

Basic EPS and diluted EPS data would give users the most factually range of possibilitiesUse of a common international method is important due to the data based oriented financial analysis and internationalization of business

The notion of common stock equivalents does not operate efficiently in practiceThe computation of primary EPS is complex and not well understood or consistently applied

Presenting basic EPS eliminates criticism about the arbitrary nature of the determination of common stock equivalentsSlide27

SFAS No. 128

Requires presentation of EPS by all publicly traded companies issuing common stock

Companies with a simple capital structure will only report basic earnings per share. All others will report basic and dilutedCalculation of basic EPS

Net income - Preferred dividends

Average # of common shares outstandingSlide28

Diluted Earnings Per Share

Objective

Historical - basicPro forma - dilutedCalculation:Includes all potential dilutive securitiesOptions and warrants - treasury stock method

Written put options – reverse treasury stock methodConvertible securities“as-if-converted”

Contingently issuable securitiesSlide29

Usefulness of EPS

Objectives of EPS reporting are to provide investors an indication of:

Value of the firmExpected future dividendsQuestion: Historical or forecasted?

Summary indicatorHershey has a complex capital structure and discloses basic as well as diluted earnings per share on its income statements

Tootsie Roll has a simple capital structures and discloses only one earnings per share figureSlide30

SFAS No 130 - Reporting Comprehensive Income

Reasons for the initial project

Off-balance sheet financingThe practice of reporting some items of comprehensive income in stockholders’ equityAcknowledged need for harmonization of accounting standardsSlide31

Definitions

Comprehensive income

The change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. Other comprehensive incomeRevenues, expenses, gains, and losses included in comprehensive income but excluded from net income.Slide32

SFAS No 130 - Reporting Comprehensive Income

Original issues:

Should comprehensive income be reported?Should cumulative accounting adjustments be included in comprehensive income?How should the components of comprehensive income be classified for disclosure?

How should comprehensive income be disclosed in the financial statements?

Should the components of other comprehensive

income be disclosed before or after their related

tax effects?Slide33

Should Comprehensive Income Be Reported?

SFAS No 130

Requires the disclosure of comprehensive income and Discusses how to report and disclose comprehensive income and its components, including net income.Does not specify when to recognize or

how to measure componentsSlide34

Should Cumulative Accounting Adjustments Be Included?

Cumulative Accounting Adjustments

Comprehensive Income

Include

As Part Of

Cumulative Accounting AdjustmentsSlide35

How Should the Components of Comprehensive Income Be Classified for Disclosure?

Requirement:

Companies must disclose an amount for net incomeThat amount must be accorded equal prominence with the amount disclosed for comprehensive income

Items of other comprehensive income are classified based on their natureSlide36

How Should Comprehensive Income be Disclosed in the Financial Statements?

Requires a gross disclosure technique for items of other comprehensive income

ASU 2011-05 allows for the disclosure of comprehensive incomeOn income statementOn a separate statement

Previous alternative treatment of disclosure in statement of stockholders’ equity no longer allowedSlide37

Allows the components of other comprehensive income to be disclosed either

Net of related tax effects orBefore related tax effects with one amount shown for the aggregate income tax expense or benefit related to the total amount of other comprehensive income

Other comprehensive income is transferred to a separate component of stockholders’ equityHershey’s discloses changes in other comprehensive income in its consolidated statement of shareholders’ equity as a single net amount. (No longer allowed)Tootsie Roll includes the calculation of other comprehensive income on its income statement.

Should Components of Other Comprehensive Income Be Displayed Before or After Their Related Tax Effects.Slide38

Prior Period Adjustments

An adjustment to beginning retained earnings balance

Original criteria in APB No. 9Examples were income tax disputes and litigation

SEC Staff Bulletin No. 8 and APB Opinion No. 16

Correction of an error

Adjustments from realization of operating loss carryforward of purchased subsidiary

Slide39

Proposed Format of the Statement of Comprehensive Income

Under Phase B of the financial statement presentation project the FASB and the IASB are planning to release a plan to recast financial statements into a new format. One possible result is the elimination of the current definition of net income. In its place, financial statement users may find a number of profit figures that correspond to different corporate activities.

The rationale for the new presentation is that focusing on the net profit number has been seen as one cause for the fraud and stock-market excesses that characterize the past several years.Slide40

Proposed Format of the Statement of Comprehensive Income

The new proposed income statement has separate categories for the disclosure of a company’s operating business, its financing activities, investing activities, and tax payments.Each category also contains an income subtotal. The proposal adopts a single statement of comprehensive income format that combines income statement elements and components of other comprehensive income into a single statement.

Items of other comprehensive income are to be presented in a separate section following the income statement elementsSlide41

Proposed Format of Statement of Comprehensive Income

Separate categories for disclosure ofOperating business activities

Financing activitiesInvesting activitiesTax paymentsSubtotal for each categoryAll income and expense items to be classified into operating, investing, and financingDisaggregate line items by functionFunction: the primary activities in which an entity is engaged

Further disaggregate line items by natureNature: the economic characteristics or attributes that distinguish assets, liabilities, and income and expense items that do not respond equally to similar economic eventsSlide42

The Value of Corporate Earnings

The financial analysis of a company’s income statement focuses on a company’s operating performance by focusing on such questions as:What are the company’s major sources of revenue?

What is the persistence of a company’s revenues?What is the company’s gross profit ratio?What is the company’s operating profit margin?What is the relationship between earnings and the market price of the company’s stock?Slide43

Sources of Revenue

The financial analysis of a diversified company requires a review of the impact of various business segments on the company as a whole. Hershey reports segmental information for two segments:Domestic

International Tootsie Roll reports segmental information for two segments:Domestic International Neither company discloses any information about major customers.Slide44

Persistence of RevenuesSlide45

Management’s Discussion and Analysis

The MD&A section of a company’s annual report can provide valuable information on the persistence of a company’s earnings and its related costs.SEC requires companies to disclose any changes or potential changes in revenues and expenses to assist in the evaluation of period-to-period deviations.

Both Hershey and Tootsie Roll indicated decrease in gross profit percentage from 2010 to 2011Slide46

Gross Profit Analysis

Gross Profit Percentage = Gross profit ÷ net salesSlide47

Net Profit Analysis

Net Profit Percentage = Net Income ÷ Net SalesSlide48

Operating Profit Percentage

Operating

Profit Percentage = Operating profit ÷ Net SalesSlide49

The Value of Corporate Earnings

The relationship between corporate earnings and stock pricesMeasured by price earnings ratio

Hershey = 21.68Tootsie Roll = 31.14

P/E Ratio

=

Current market price per share

÷

EPSSlide50

Price-Earnings Ratios

Operating

Profit Percentage = Operating profit ÷ Net SalesSlide51

International Accounting Standards

In addition to release of IAS No. 33 on EPS, IASB has:

Defined the concepts of performance and income in “Framework for the Preparation and Presentation of Financial Statements”

Discussed the content and format of the income statement in IAS No. 1, “ Presentation of financial Statements”

Discussed some components of the income statement in an amended

IAS No. 8,

now titled "Accounting Policies, Changes in Accounting Estimates and Errors"

Defined the concept of revenue in IAS No. 18, “Revenue”

Amended IAS No. 33

Discussed the required presentation and disclosure of a discontinued operation in IFRS No. 5, “Non-Current Assets Held for Sale and Discontinued Operations”

Issued a proposed amendment to IAS No. 1Slide52

IASB Definitions of Performance and Income

Profit is used

To measure performance

Or as the basis for other measures

Measurement of income is

dependent on

The concept of capital maintenance used by the enterprise

Physical capital maintenance

Financial capital maintenanceSlide53

IASB Definitions of Performance and Income

The IASB definition of income

encompasses both revenue and expenses

The IASB has not made the distinction between ordinary and nonordinary

operations contained in

SFAC No. 6

A proposed standard would require a “Statement of Non-owner Movements in Equity”

Encourages an analysis of income and expenses based on their nature or function in the enterpriseSlide54

International Accounting Standards

IAS No. 1Requires income statement that includesRevenue

Results of operationsFinance costsGains & losses from equity investmentsTax expenseProfits or losses from ordinary activitiesMinority interestNet profitDoes not require discontinued operations or accounting changes to be reported separatelyDoes not allow items to be classified as ordinarySlide55

IAS No. 8:

Accounting Policies, Changes in Accounting Estimates and ErrorsOriginally, IAS No. 8Defined the concepts of Net profit or loss from ordinary activitiesExtraordinary items

Accounting changesFundamental errors

Each of these income statement items was

defined and reported in a manner similar to U.S. GAAP

with the exception of fundamental errors

The revised IAS No. 8

Does not distinguish between ordinary and extraordinary items

Eliminates the concept of fundamental errors

Slide56

IAS No. 8:

Accounting Policies, Changes in Accounting Estimates and ErrorsA GAAP hierarchy indicates that the following sources must be applied in descending order of authoritativeness:

International Financial Reporting Standard, including any appendices that form part of the Standard

Interpretations

Appendices to an IFRS that do not form part of the Standard

Implementation guidance issued by IASB in respect of the StandardSlide57

Errors

Now defined as newly discovered omissions or misstatements of prior period financial statements based on information that was available when the prior financial statements were preparedAll material errors will be accounted for retrospectively By restating all prior periods presented

And adjusting the opening balance of retained earnings of the earliest prior period presentedCumulative effect recognition in income is prohibitedIAS No. 8: Accounting Policies, Changes in Accounting Estimates and ErrorsSlide58

IAS No. 18 - Revenue

Revenue should be recognized when:

The enterprise has transferred to the buyer the significant risks and rewards of ownership of goodsThe enterprise doesn’t retain managerial involvement or control over the goods sold

The amount can be measured reliablyIt is probable that economic benefits associated with the transaction will flow to the enterprise

The costs associated with the transaction can be measured reliablySlide59

IAS No. 18 - Revenue

U. S. GAAP does not specifically address the issue of revenue

If it did, there would probably be a difference because of the IASC use of the term probable future economic benefitSlide60

IAS No. 35: Discontinued Operations

The amended IAS No. 33 incorporated the following additional disclosures and guidelines:

Basic and diluted EPS must be presented for (a) Profit or loss from continuing operations and (b) Net profit or loss …on the face of the income statement for each class of ordinary shares, for each period presented.Potential ordinary shares are dilutive only when their conversion to ordinary shares would decrease EPS from continuing operations

(IAS 33 previously used net income as the benchmark).Slide61

IAS No. 35: Discontinued Operations

For contracts that may be settled in cash or

shares, now includes a rebuttable presumption that the contract will be settled in shares.If an entity purchases (for cancellation) its own preference shares for more than their carrying amount, the excess (premium) should be treated as a preferred dividend in calculating basic EPS (deducted from the numerator of the EPS computation).Guidance is provided on how to calculate the effects of contingently issuable shares; potential ordinary shares of subsidiaries, joint ventures, or associates: participating securities; written put options; and purchased put and call options.Slide62

IFRS No. 5: Non-Current Assets Held for Sale and Discontinued Operations

SFRS No. 5 replaces IAS No. 35. Discontinued operations

Post-tax profit or loss of the discontinued operation

Post-tax gain or loss recognized on the measurement to fair value

Cost to sell or fair value adjustments on the disposal of the assets (or disposal group)

+

-

Should be presented as a single amount on the face of the income statementSlide63

IFRS No. 5: Non-Current Assets Held for Sale and Discontinued Operations

Detailed disclosure of revenue, expenses, pre-tax profit or loss, and related income taxes is required Either in the notes or on the face

of the income statement in a section distinct from continuing operations. Such detailed disclosures must cover both the current and all prior periods presented in the financial statements. IFRS No 5 prohibits the retroactive classification as a discontinued operation, when the discontinued criteria are met after the balance sheet date. Slide64

Proposed Amendment to IAS No.1

Similar to the FASB’s proposed Accounting Standards Update on the Statement of Comprehensive Income; however, there are some differences. The IASB chose to title the new statement “The Statement of Profit or Loss and other Comprehensive Income.” The new guidance would not change those components that are recognized in other comprehensive income under either accounting framework

Additionally, the two frameworks differ on the treatment of some of those components and total convergence not achieved.The Boards believe that the proposals are an important step in enhancing comparability and providing greater transparency.Slide65

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2014

John Wiley & Sons, Inc.  All rights reserved.Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful.  Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc.  The purchaser may make back-up copies for his/her own use only and not for distribution or resale.  The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.Prepared by Kathryn Yarbrough, MBA