FA2 Module 2' Income statement and balance sheet presentation

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FA2Module 2. Income statement and balance sheet
presentation

• Income statement and statement of retained
  earnings
• Balance sheet

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I. Income statement

• Theoretical considerations
• Income statement formats
• Components of net income
• Extraordinary items and unusual items
• Intraperiod tax allocation
• Discontinued operations
• Comprehensive income

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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 evaluate
  past performance (feedback value)
• I/S information helps predict future cash flows
  and risk associated with them

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Limitations of the income statement

• What is income?
• Hicks Income is the maximum amount entity can
  distribute to its owners while still maintaining
  the entitys net worth
• Earnings figures depend on accounting methods and
  accounting estimates
• Some firm assets are not recognized as assets
  income and net worth are therefore understated

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Measuring net worth

• In order to measure net income, we must be able
  to measure net worth. Possibilities
• Nominal dollars (CICA answer)
• Constant dollars (inflation-adjusted)
• Maintenance of productive capacity
• Other assumptions/principles
• Time-period
• Revenue recognition and matching

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Calculating net income

• Suppose we have decided how to measure net worth
  (nominal dollars in Canada). What is the next
  step?
• Capital maintenance approach Income change in
  net worth emphasis on statement of retained
  earnings
• Transaction approach Focus on the transactions
  that cause changes in net worth emphasis on
  income statement

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Transaction approach Elements of the income
statement

• Revenues Increases in economic resources that
  result from ordinary activities of the entity,
  usually from sale of goods or provision of
  services also rent, interest, royalties or
  dividends from investments
• Expenses Decreases in economic resources
  resulting from ordinary revenue-generating
  activities of the entity

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Transaction approach Elements of the income
statement (continued)

• 3. Gains Increases in equity from peripheral or
  incidental transactions and events and other
  transactions or events other than revenues or
  equity contributions
• 4. Losses Decreases in equity from peripheral
  or incidental transactions and events and other
  transactions or events other than expenses or
  distributions of equity

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2. Income statement formats

• Single step income statement
• Revenues (and gains, if any)
• Expenses (and losses, if any)
• Net income
• Advantages
• Simplicity of presentation
• User decides what is important, not management

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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, losses

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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
• Note that either format (single- or multiple-) is
  permitted under GAAP.
• Example A3-9

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3. 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.

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What is relevant income?

• Net income
• Income before extraordinary items
• Income from continuing operations
• EBITDA (earnings before interest, tax,
  depreciation and amortization)
• Pro forma earnings (includes EBITDA)
• Core earnings (Standard Poors)

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Bell Canada 2005 earnings
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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 companys 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, 2001

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3. Components of net income

• CICA approach A modified all-inclusive concept
• Unusual items are included in income, but some
  (discontinued operations, extraordinary items)
  are presented separately on the income statement
  in order to highlight income from continuing
  operations and before extraordinary items.
• This enhances the predictive power of the I/S.

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Items that affect shareholders equity where do
they go?

• Income statement revenues, expenses, most gains
  and losses
• Statement of retained earnings 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 instruments

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4. Extraordinary items

• An item is considered extraordinary if it meets
  all of the three following criteria
• Unusual in nature (not typical of normal business
  activities)
• Not expected to occur frequently over several
  years.
• Does not depend primarily on decisions or
  determinations by management or owners

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Spot the extraordinary items

• 1. An earthquake destroys one of the oil
  refineries owned by a large multinational oil
  company. Earthquakes are rare in this
  geographical region.

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Spot the extraordinary items

• 2. A large diversified company sells a block of
  shares from its portfolio of securities acquired
  for investment purposes.
• 3. A company sells a block of common shares of a
  publicly traded company. The block of shares . .
  . is the only security investment the company has
  ever owned.

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Spot the extraordinary items

• 4. A textile manufacturer with only one plant
  moves to another location and sustains relocation
  costs of 725,000.
• 5. A railroad experiences an unusual flood loss
  to part of its track system. Flood losses
  normally occur every three or four years.

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Income statement presentation of extraordinary
items

• Extraordinary items are presented net of tax in a
  separate section of the income statement, usually
  just before net income.
• Revenues X
• Expenses (including income tax
• on ordinary items) Y
• Income before extraordinary item X-Y
• Extraordinary item (net of inc. tax) Z
• Net income X-Y-Z

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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, extraordinary items) should be
  related to the specific item on the income
  statement.

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Example Viger Ltd.
Prepare an income statement that is consistent
with CICA recommendations.
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6. Discontinued operations

• When a company closes down or sells some
  component of its organization, it might need to
  report the component as a discontinued operation.
• A discontinued operation is a component . . .
  that can be clearly distinguished, operationally
  and for financial reporting purposes, from the
  rest of the enterprise (CICA 3475).

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Financial statement presentation

• Objective Enhance predictive ability of
  financial statements
• Income statement Discontinued operation
  revenues, expenses, gains and losses removed from
  continuing activities and reported separately
• Balance sheet Discontinued operation assets and
  liabilities segregated on balance sheet assets
  classified as held-for-sale (amortization
  ceases)

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When is an operation discontinued?

• An operation is held for sale when
• Management commits itself to sell
• Operation is available for immediate sale
• Buyer is being sought, or plan to shut down has
  begun
• Sale/shutdown is probable and expected to be
  completed within one year
• Sale price is reasonable
• Unlikely that plan will change significantly

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Income statement presentation

• Presented as a single item on the income
  statement, net of income tax, after income from
  continuing operations but before extraordinary
  items, that includes
• Net profit or loss from operating the
  discontinued operation during the current year
• Writedown of asset carrying values to fair value
  less cost to sell
• Any unanticipated gain or loss on disposal
  (completed shutdowns)
• Example A3-22

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7. 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.

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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 A3-13

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II. The Balance Sheet

• Uses and limitations of the balance sheet
• Balance sheet classifications
• Balance sheet formats
• Supplemental disclosure

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1. Uses and limitations

• Uses of balance sheet 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)

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1. Uses and limitations (continued)

• Balance sheet limitations
• Historical cost basis of valuing many assets and
  liabilities
• Use of estimates and accounting choices
• Balance sheet 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 consolidated

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2. Balance sheet 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 characteristics

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2. Balance sheet 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 (PPE plus intangibles)
• Other assets (e. g., deferred charges)

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2. Balance sheet classifications

• Current assets are cash and other assets that are
  expected to 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.

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Current assets (order of liquidity)
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2. Balance sheet 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)
• Contingencies

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2. Balance sheet 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 liabilities

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3. Balance sheet formats
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3. Balance sheet formats
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3. Balance sheet formats
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3. Balance sheet formats
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Example A4-11
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4. Supplemental balance sheet disclosure

• Contingencies material events that have an
  uncertain outcome
• Valuation and accounting policies usually
  footnote 1
• Contractual situations covenants or
  restrictions attached to specific assets or
  liabilities commitments
• Post-balance sheet events

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Post-balance sheet events

• The post-balance sheet events (or subsequent
  events) period is the period between the date of
  the balance sheet and the date of publication of
  the annual report.
• Subsequent events occur in time to have an impact
  on the previous years annual report, if
  necessary.

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Types of subsequent events

• Events that 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.

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Types of subsequent events

• Events that provide information about conditions
  that did not exist and do not require adjustment
  to the financial statements. This information
  should be disclosed as a supplementary note if it
  affects the financial condition of the entity.
  Examples include
• Fire or flood
• Decline in value of investments
• Issues of share capital or long-term debt

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Subsequent events that do not require adjustment
or 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
• Unionization

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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 customer

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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 customers bankruptcy
• Hiring of a new president
• Settlement of a prior years litigation against
  the company
• Merger with another company of comparable size