FA2 Module 2. Income statement and statement of financial - PowerPoint Presentation

Slide1

FA2Module 2. Income statement and statement of financial position presentation

Statements of income and comprehensive income

Statements of financial position and changes in equity

Remember the attendance sheet!Slide2

I. Statements of income and comprehensive income

Theoretical considerations

Income statement presentation

Asset disposals

Discontinued operations

Intraperiod

tax allocation

Comprehensive incomeSlide3

1. Theoretical considerations

The income statement is the most important financial statement, and net income the most important figure:

EPS widely predicted and published; earnings surprises rewarded (or punished)

Income statement information helps to confirm past predictions (feedback value)

I/S information helps

predict

future cash flows and risk associated with themSlide4

Nature of income

Economic income

: Income is change in wealth –

events approach

,

i

. e., watch for events that change wealth (e. g., changes in fair value of asset)

Accounting income

: Traditionally based on

transactions approach

,

i

. e., income is recognized only as result of transactions (e. g., item sold for amount different than its historical cost)

More recently

, accounting income moving closer to economic incomeSlide5

Nature of income (cont’d)

Comprehensive income

all changes to owners’ equity not the result of transactions with owners in their capacity as owners (e. g., dividends, share capital)

Two categories of comprehensive income

Periodic profit/loss (net income)

Other comprehensive income (OCI) – changes in balance sheet values that are not yet recognized in net income (profit or loss)Slide6

Nature of income (cont’d)

Items not included in net income

all changes to owners’ equity that result from transactions with owners in their capacity as owners (e. g., dividends, share capital)

OCI (other comprehensive income)

cumulative adjustments to retained earnings that result from changes in accounting policies and corrections of errorsSlide7

Nature of income (cont’d)

Presentation of comprehensive income

1. Single statement that combines income statement and OCI

Revenue $

Expense

$

Net income $

OCI

$

Comprehensive income

$Slide8

Nature of income (cont’d)

Presentation of comprehensive income

2. Income statement plus statement of comprehensive income

Revenue $

Expense

$

Net income

$

Net income $

OCI

$

Comprehensive income

$Slide9

2. Income statement presentation

Required components (IFRS)

Revenues

Finance costs (interest expense)

Share of earnings from associated cos.

Profit or loss on discontinued operations, net of tax

Net income

Earnings per share

Lots of additional note disclosureSlide10

2. Income statement presentation

Alternative formats

Classification by nature of expense

Classification on the basis of inputs – what the money was spent on (e. g., salaries, amortization)

Classification by function

Output-based classification – what money was used for (cost of goods sold, operating expenses, selling and administrative expenses)Slide11

Example: Nature vs. FunctionChen Inc.

Expense

Depreciation

Salaries

Other

Total

Cost of goods sold

$500

Selling

$120

$100

$40

260

Administrative

60

110

30

200

Total

$180

$210

$70

$960

Revenue for the year was $1,400. Prepare an

income statement for Chen for the year, classifying expenses by (a) nature and (b) function.Slide12

(a) Chen Inc.Income statement: Expenses classified by nature

Chen Inc.,

Income

Statement for the year ended December 31

Revenue

Cost

of Goods Sold

Depreciation expense

Salaries expense

Other expenses

Net income

$1,400

500

180

210

70

$440Slide13

(b) Chen Inc.Income statement: Expenses classified by function

Chen Inc.,

Income

Statement for the year ended December 31

Revenue

Cost

of Goods Sold

Selling expense

Administrative expense

Net income

$1,400

500

260

200

$440Slide14

2. Income statement formats

1. Single-step income statement

Revenue $

Expenses

$

Net income

$

Simple presentation, allows (forces) users to decide what importance to attach to each item.

Disadvantages

: GAAP requires separate presentation of items like discontinued operationsSlide15

2. Income statement formats

Multiple-step income statement

Often includes:

Separation of results related to normal vs. unusual activities

Expenses grouped by functional category: cost of goods sold, selling expenses, administrative expenses

Separate presentation of other, non-operating items: interest, gains, lossesSlide16

2. Income statement formats

Multiple-step income statement

Advantages:

Arguably more informative in that operating and non-operating items are separated

Better matching of expenses with related revenues

Example: A3-6Slide17

3. Asset disposals and restructuring

Asset disposal means disposal of a (usually non-current) asset by abandonment or sale.

Abandoned asset

: No longer used in company operations but there are no plans to sell. Amortization stops, asset is written down to lower of net realizable value (fair value less costs to sell) and carrying value.

Asset remains classified as non-current.Slide18

Planned disposal of assets by sale

Individual assets

Current assets

: Written down to lower of NRV and carrying value and left as current asset

Non-current assets

: Once removed from use, amortization ceases. Asset written down to lower of NRV and carrying value. If right conditions are met, asset is classified as

held-for-sale

and reclassified as current asset.Slide19

Conditions for held-for-sale classification

Asset available for immediate sale in present condition

Asset sale is highly probable

Price asked for asset is reasonable

Active program to find buyer has started

Management committed to selling asset

Unlikely that offer to sell will be withdrawn or terms significantly changed

Sale expected to take place within one year of reclassification as held-for-saleSlide20

Recording non-current asset as held-for-sale

Asset is

remeasured

at lower of NRV and current carrying value; any loss determined as result of

remeasurement

is recognized

Asset is reclassified as held-for-sale if all of the criteria are met

Amortization ceases. Accumulated depreciation is eliminated.Slide21

Recording non-current asset as held-for-sale

Example: A3-14 (c):

Panych

ceased to use a company-owned cargo plane on September 30. The plane cost $7,000,000 and now has a carrying value of $2,400,000. The company plans to find a buyer as quickly as possible, and has engaged a dealer to look for a buyer. The agent expects to find a buyer within the following six to eight months. The asking price is $2,000,000. The dealer will take a 3% commission on the sale.

Prepare journal entries and show how

the assets will

be reported on balance sheet.Slide22

4. Discontinued operations

A discontinued operation is an operating segment that contains a “cash generating unit” (group of assets that generates cash flows that are independent of cash flows from other assets or groups of assets) and has either been sold or is held-for-sale (same criteria as for assets).

The segment is separable from the rest of the organization.

Under IFRS, discontinued operations are only

major

organizational segments.Slide23

Components of net income

Current operating performance concept

Net income should contain only regular, recurring revenues and expenses. Unusual items should be presented on statement of retained earnings.

All-inclusive concept

All gains and losses should be included in net income.Slide24

What is “relevant” income?

Net income

Income from continuing operations

EBITDA (earnings before interest, tax, depreciation and amortization)

Pro forma earnings (includes EBITDA)

Core earnings (Standard &

Poors

)Slide25

Bell Canada 2010 earnings release

Earnings figure

Total ($ billion)

Net earnings for common

$2.165

Net earnings before investments, restructuring and other

$2.159

Operating income

$3.292

EBITDA*

$7.188

Free cash flow*

$1.374Slide26

Why calculate a second earnings figure?

“Because the numbers reached by applying GAAP are woefully inadequate when it comes to giving investors a good sense of a company’s prospects. Many institutional investors, most Wall Street analysts, and even many accountants say GAAP is irrelevant . . . The problem is that GAAP includes a lot of noncash charges and one-time expenses.”

- Business Week, November 26, 2001Slide27

Components of net income

IFRS approach: A modified all-inclusive concept

Unusual items are included in income, but discontinued operations are presented separately on the income statement in order to highlight income from continuing operations.

This enhances the predictive power of the I/S.Slide28

Items that affect shareholders’ equity – where do they go?

Income statement

: revenues, expenses, most gains and losses

Statement of changes in equity

: effects of changes in accounting policy, error corrections, effects of some capital transactions

Other comprehensive income

: unrealized gains and losses on held-for-sale assets, translation of statements of some foreign subsidiaries, some hedging instrumentsSlide29

Discontinued operations and the financial statements

Income statement

Net profit or loss from operating discontinued operation until date of disposal or year-end if disposal not complete by year end, net of income tax

Writedowns

of asset carrying values to net realizable value, plus all realized gains and losses on disposal not previously recognized, net of income taxSlide30

Discontinued operations and the financial statements

Statement of financial position

Assets are reclassified as held-for-sale and reported as single current asset

Liabilities associated with segment are reclassified as single current liabilitySlide31

Discontinued operations example

On September 1, Hatchet Ltd. closed and decided to sell off its unprofitable Service Division. The division has non-current capital assets with a carrying value of $300 (cost = $500, accumulated depreciation = $200) and a fair value of $250. Selling costs are expected to be $10. Its current assets have a carrying value and fair value of $100. Hatchet’s tax rate is 40%.

Prepare the journal entry required on Sept. 1.Slide32

5. Intraperiod tax allocation

Income tax expense depends on all other income statement items.

Inc. tax exp = Tax rate (R) X Inc before tax

= (R X Revenue) – (R X Expenses) + . . .

Guiding principle

The income tax effect of major income statement items (continuing operations, discontinued operations) should be related to the specific item on the income statement.Slide33

Example: Viger Ltd.

Viger

Ltd

Income statement for the year ending Dec. 31, 2010

Revenue

Operating expenses

Loss on operation of discontinued op.

Gain on sale of investment

Income before tax

Income tax expense (40%)

Net income

$400

150

40

60

270

108

$162

Prepare an income statement that is consistent with

IFRS.Slide34

6. Comprehensive income

In 2006, Canadian firms had to start reporting

comprehensive income

, composed of (1) net income and (2) other comprehensive income (OCI).

OCI includes unrealized gains and losses on certain types of transactions – available-for-sale assets, translation of financial statements of a certain type of foreign subsidiaries, and cash flow hedges related to anticipated transactions.Slide35

Other comprehensive income on the balance sheet

OCI recognized each year accumulates in the “Cumulative other comprehensive income” account (a shareholders’ equity account) on the balance sheet. When the gains and losses included in OCI are realized, they are transferred from Cumulative OCI to Income statement gain and loss accounts.

Example: A3-9Slide36

II. Statements of Financial Position (SFP) and Changes in Equity

Uses and limitations of the SFP

SFP classifications

SFP formats

Statement of Changes in Equity

Disclosure notes

Remember the attendance sheet!Slide37

1. Uses and limitations

Uses of SFP information

Compute rates of return (income vs. assets and owners’ equity)

Evaluate firm capital structure (debt vs. equity financing)

Assess liquidity (ability to meet obligations coming due) and financial flexibility (ability to alter cash flows to meet unexpected needs or take advantage of unexpected opportunities)Slide38

1. Uses and limitations (continued)

SFP limitations

Historical cost basis of valuing many assets and liabilities

Use of estimates and accounting choices

SFP omits many items that are of financial value to the firm but cannot be measured reliably (e. g., human resources, internally generated goodwill)

Numbers are consolidatedSlide39

2. SFP classifications

Overriding principle: Provide sufficiently detailed information to permit users to assess future cash flows (amounts, timing and uncertainty) and the liquidity, financial flexibility, profitability and risk of the entity. Balance sheet items are sorted according to:

Type or expected function (assets)

Implications for financial flexibility

Liquidity characteristicsSlide40

2. SFP classifications

Assets

are resources controlled by an enterprise as a result of past transactions or events from which future benefits may be obtained.

Current assets (cash, accounts receivable, inventories, prepaid expenses)

Investments (current and non-current)

Capital assets (PP&E plus intangibles)

Other assets (e. g., deferred charges)Slide41

2. SFP classifications

While not required under IFRS, most Canadian companies distinguish between current and non-current assets and liabilities.

Current assets

are cash and other assets that are expected to be converted into cash, sold or consumed within one year or one operating cycle, whichever is longer.

The

operating cycle

is the conversion of cash into inventory (through purchase and/or production), then into accounts receivable (through sale) and, finally, back into cash.Slide42

Current assets (order of liquidity)

Item

Valuation

Cash

Market value

Temporary investments

Market value

Accounts receivable

Realizable value

Inventory

Lower of cost and net realizable value

Prepaid expenses

CostSlide43

2. SFP classifications

Liabilities

are obligations of an enterprise arising from past transactions or events, the settlement of which may result in the transfer of assets, provision of services, or other yielding of economic benefits in the future.

Obligations related to operations (accounts payable, future income taxes)

Unearned revenue

Obligation from financing (loans, bonds)

ContingenciesSlide44

2. SFP classifications

Current liabilities

are obligations that are reasonably expected to be settled through the use of current assets or the creation of other current liabilities (usually, liabilities due within one year)

Accounts payables

Accrued liabilities (e. g., wages payable)

Unearned revenue

Current portion of long-term liabilitiesSlide45

Example: A4-11Slide46

4. Statement of changes in equity (SCE)

Discloses the components of equity and the changes in each of those components during the reporting period. Typical components are:

Share capital

Additional paid-in capital/contributed surplus

Equity components of hybrid instruments

Retained earnings

Cumulative other comprehensive income

Non-controlling interestSlide47

SCE Example

The balances in Richmond

Inc.’s shareholders equity accounts on December 31, 20x8 were as follows:

Common shares

Retained earnings

Total

$500

$250

$750

During 20x9, Richmond changed accounting methods to provide more relevant information to shareholders.

The cumulative effect was to increase retained earnings by $60 as of Dec. 31, 20x8. Richmond issued common shares during 20x9 for $120. 20x9 net income was $35 and cash dividends of $40 were declared.Slide48

5. Disclosure notes

Compliance statement (GAAP used)

Accounting policies

New accounting standards not yet in effect

Additional detail required by standards

Major underlying assumptions and estimatesSlide49

5. Additional disclosures

Contingencies: material events that have an uncertain outcome

Guarantees

Segment reporting

Related party transactions

Economic dependence

Unrecognized contractual commitments

Financial risk management objectives and policies

Subsequent eventsSlide50

Subsequent events

The or subsequent events period is the period between the date of the statement of financial position and the date of publication of the annual report.

Subsequent events occur in time to have an impact on the previous year’s annual report, if necessary.Slide51

Types of subsequent events

Adjusting events

provide additional information about conditions existing at the balance sheet date, information that affects estimates used in preparing the financial statements. An adjustment is required.

This is generally information that would have been in the financial statements were it available.Slide52

Types of subsequent events

Non-adjusting events

provide information about conditions that did not exist and do not require adjustment to the financial statements. This information will affect next year’s financial statements and should be disclosed. Examples include:

Fire or flood

Decline in value of investments

Issues of share capital or long-term debtSlide53

Non-adjusting events that do not require disclosure

These are typically nonaccounting events or events that are generally communicated to users through other means. Examples include:

Legislation

Product changes

Management changes

Strikes

UnionizationSlide54

Subsequent events exercise

For each of the following subsequent events, should company (a) adjust financial statements; (b) disclose in note; (c) neither adjust nor disclose?

Settlement of tax case for amount in excess of amount estimated at year end

Introduction of new product line

Loss of assembly plant due to fire

Sale of significant portion of company assets

Retirement of company president

Prolonged employee strike

Loss of significant customerSlide55

Subsequent events exercise

Should company (a) adjust financial statements; (b) disclose in note; (c) neither adjust nor disclose?

Issuance of significant number of common shares

Material loss on year-end receivable because of a customer’s bankruptcy

Hiring of a new president

Settlement of a prior year’s litigation against the company

Merger with another company of comparable size