Sammy Skateboard Results: 20 mean (25 points)

1
Announcements

• Sammy Skateboard Results 20 mean (25 points)
• Quiz 1 Results 11.6 mean (17 points)
• Project 1 due Monday 1/29 (extended from 1/24).
  Be prepared to discuss in class
• Midterm 1 is Monday 2/5

2
The Income Statement

• The income statement lists the following for a
  firm over a period of time
• Revenues
• Expenses
• Gains
• Losses
• The excess of revenues and gains over expenses
  and losses is equal to net income (or net loss,
  if negative) for the period. SEC rules requires
  firms to report 3 years of income statement data.

3
Usefulness of the Income Statement

• Evaluate past performance of a company
• Feedback value
• Provide a basis for predicting future performance
• Predictive value
• Assist in assessing the risk or uncertainty of
  future cash flows
• Predictive value

4
Limitations of the Income Statement

• Limitations of the Income Statement
• Does not report items that cannot be measured
  reliably (e.g. unrealized gains/losses on certain
  investment securities, intangible items such as
  brand recognition, customer satisfaction, product
  quality).
• Reported income is a function of the accounting
  methods a company uses (e.g. different
  depreciation methods within GAAP).
• Managers exercise judgment in measuring income.

5
The Income Statement Earnings Management

• Managers timing reporting of revenues, expenses,
  gains and losses to meet their incentives
• Generally used to increase income in the current
  year at the expense of income in future years
• Can also be used to decrease income in current
  year in order to increase income in future periods

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The Income Statement Earnings Management

• Examples
• AOL Time Warner
• Bristol-Myers Squibb
• Enron
• Worldcom
• Xerox

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Income Statement Elements

• Ongoing Activities
• Revenues increases in assets or decreases in
  liabilities
• Expenses decreases in assets or increases in
  liabilities
• Incidental or Peripheral Activities
• Gains increases in assets or decreases in
  liabilities
• Losses decreases in assets or increases in
  liabilities

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Income Statement Presentation

• Single-Step Income Statement
• Groups together all revenues and all expenses and
  Net Income is the difference between the two
  groups.
• Used by approximately 25 of firms
• No distinction between operating and
  non-operating activities
• Eliminates potential classification issues

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Single-Step Income Statement
The single-step statement consists of just two
groupings
Revenues Expenses Net Income
Single- Step
No distinction between Operating and
Non-operating categories.
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Income Statement Presentation

• Multiple-Step Income Statement
• Divides information into major sections on the
  statement.
• Differentiates between operating and
  non-operating activities.
• Continuing operations are shown separately from
  irregular items. Income tax effects are shown
  separately as well.
• Prepared with objectives of financial reporting
  in mind, particularly (1) enabling users to
  predict amounts, timing and uncertainty of future
  cash flows and (2) providing information on
  available resources and claims to those resources.

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Multi-Step Income Statement
The presentation divides information into major
sections.
1. Operating Section
2. Nonoperating Section
3. Income tax
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Income Statement Presentation

• Section 1 Operating Section
• Contains information about the operating activity
  of a business.
• Revenues from continuing operations
• Cost of products sold or services performed
• Other operating expenses
• These items are grouped together because the
  activity underlying the numbers is likely to
  continue, and investors and others may wish to
  use information as basis for extrapolating into
  the future. May also include unusual gains and
  losses that occur relatively infrequently, but
  arise from the companys ongoing operations.

13
Income Statement Presentation

• Section 2 Non-operating Section
• Contains information about interest expense and
  revenue and other gains and losses of the firm.
• Separating interest expense provides information
  about claims on resources, since debt holders
  usually have priority claim over shareholders.
• Other gains and losses relate to transactions
  that may or may not recur, and separating those
  items presumably allows users to more accurately
  reflect the future.

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Income Statement Presentation

• Section 3 Income tax
• Deducts taxes - also provides information about
  claims on resources
• Section 4 Irregular items
• Relates to special items that are not expected to
  recur. The FASB believes that the nature of these
  items is such that they should be explicitly
  disclosed at the bottom of the income statement
  and reported net of tax consequences
• Discontinued operations
• Extraordinary items

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Reporting Irregular Items

• Discontinued Operations
• Basic criteria (see SFAS144 for more detail)
• The results of operations and cash flows of a
  component of a company have been (or will be)
  eliminated from ongoing operations.
• No significant continuing involvement in that
  component after disposal transaction.

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Reporting Discontinued Operations

• There are two important dates in reporting
  discontinued operations
• the measurement date (when management commits
  itself to a plan of segments disposal) and
• the disposal date (the date of sale of the
  segment).
• The time between the measurement date and the
  disposal date is often called the phase-out period

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Time Line for Discontinued Operations
Measurement Date
Year-end
Final Disposal
Year-end
Loss from Operations (B)
Prior year reclassify into loss from op. (A)
Part of Loss on Disposition (C)
Part of Loss on Disposition estimate future
disposal costs and accrue (D)
Combine actual portion (C) estimated portion
(D) Loss on Disposition on I/S
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Example Albertsons (2003)
January 30, 2003 January 31, 2002 Earnings
from continuing operations before taxes
1,405 863 Income tax expense
540
367 ---------------------------------------
----------------- ----------- Earnings from
continuing operations 865
496 Discontinued operations Operating (loss)
income (50) 10
Loss on disposition
(379) - Tax
(benefit) expense (143)
5 ----------------------------------
--- ----------------- ----------- Net (loss)
earnings from discontinued operations
(286) 5
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Reporting Irregular Items

• Discontinued Operations
• Presentation
• Writedown of assets to fair value less costs to
  sell if less than carrying value. No write-up
  recorded if fair value greater than carrying
  value.
• Results of operations for both current and prior
  periods are required to be reported as part of
  discontinued operations.
• Both items are reported net of tax (i.e. below
  the line).

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Reporting Irregular Items

• Extraordinary Items
• Item must meet BOTH of the following criteria
• Event/transaction must be unusual in nature.
  Such items are of a significantly different
  character than typical business activities of the
  firm and would not normally be considered in
  evaluating operating results.
• Event/transaction must occur infrequently. The
  transaction would not be expected to recur in the
  foreseeable future in the environment in which
  the business operates.
• Items are reported net of tax (i.e. below the
  line).

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Reporting Irregular Items

• Items that are NOT Extraordinary Items under
  GAAP
• Losses from write-down or write-off of
  receivables, inventories, etc.
• Gains and losses from exchange or translation of
  foreign currency.
• Gains and losses on disposal of a segment of a
  business.
• Gains and losses from the abandonment of property
  used in business
• Effects of strike
• Adjustments or accruals on long term contracts.

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Reporting Irregular Items

• Extraordinary Items
• The environment in which a firm operates is an
  important consideration in determining whether a
  gain or loss is extraordinary.
• Hail damage may be considered to be extraordinary
  in certain locales, but not in others.
• Frost damage in Florida does not qualify as
  extraordinary because happens every few years.
• It is rare that events/transactions qualify for
  extraordinary reporting.

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Reporting Irregular Items

• Extraordinary Items
• Why does GAAP make it so difficult for a gain or
  loss to qualify as extraordinary?
• How do you expect losses associated with
  Hurricane Katrina will be treated?

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Reporting Irregular Items

• Unusual gains or losses Gains or losses that
  are material and typical of customary business
  activities. They are generally unusual or
  infrequent, but not both.
• Reporting
• Do not qualify as extraordinary and must be
  reported above the line in either operating or
  non-operating section of the income statement.
  This is an area where managers exercise
  discretion in presentation.

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Accounting Changes

• Categories of Accounting Changes
• Change in Accounting Principle
• Change in Accounting Estimate
• Errors in Financial Statements

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Accounting Changes 3 possible approaches to
apply

1. Currently. Report cumulative effect of the
   change in the current period on current year
   income statement.
2. Retrospectively. Adjust prior years statements
   that are presented in the financial statements to
   reflect the newly adopted principle. Record any
   cumulative effect as an adjustment to beginning
   R/E for earliest period presented.
3. Prospectively. No change is made to previously
   reported results. No cumulative adjustment.
   Apply new principle on in current and future
   periods.

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Accounting Changes

• Changes in Accounting Principles
• Company adopts different accounting principle
  from the one previously used (e.g. change in
  inventory pricing from FIFO to average costing).
• Company must demonstrate that newly adopted
  principle is preferable to the old one since such
  changes mean consistency across periods is lost.
• Previous reporting Current approach was used.
  Cumulative effect of the change reported below
  the line with discontinued operations and
  extraordinary items. Prior years statements
  were not restated.

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Accounting Changes

• Changes in Accounting Principles
• FAS154 (effective for fiscal years beginning
  after May 15, 2005) adopts retroactive approach.
• Recognized by making a retroactive adjustment
  unless it is impracticable to do so.
• Prior years statements presented in the
  financial statements are recast on a basis
  consistent with the newly adopted principle.
• Adjust beginning retained earnings for the
  earliest year presented to reflect any cumulative
  effect on periods prior to those presented.
  (Note no cumulative effect is reported on the
  Income Statement).

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Accounting Changes

• Changes in Accounting Estimates
• Application of certain accounting concepts
  requires the use of estimates. For example, the
  matching concept requires an estimate of the life
  of long-lived assets. Other estimates include
  uncollectible accounts and warranty liabilities.
  Managers may need to update these estimates as
  new information becomes available.

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Accounting Changes

• Changes in Accounting Estimates
• Reporting
• The effects of changes in accounting estimates
  are reported prospectively. Change is reported
  in the period of change and any future periods
  affected, with no consideration to
  revising/restating previous periods. Changes are
  reflected in the accounts affected and are not
  reported below the line.

31
Correction of Errors

• Examples
• Change from an accounting principle that is not
  GAAP.
• Mathematical mistakes
• Changes in estimate that occurs because estimates
  not prepared in good faith.
• Oversights, such as failure to accrue or defer
  certain expenses and revenues at end of period.
• Misuse of facts, such as failure to use salvage
  value in computing depreciation base for
  straight-line depreciation.
• Incorrect classification of a cost as expense
  instead of an asset and vice versa.

32
Correction of Errors

• Report corrections of errors as prior period
  adjustments (Restatement).
• Record as a direct entry to retained earnings in
  the year in which the error was discovered.
• Errors from previous periods do not flow through
  current period income.
• Restate prior statements presented to correct for
  the error.

33
Intra-period Tax Allocation

• Tax expense for year related to specific items.
• Used for
• Income from continuing operations
• Discontinued operations
• Extraordinary items

34
Irregular Items
Reporting when both Discontinued Operations
and Extraordinary Items are
present.
Discontinued Operations
Extraordinary Item
35
Earnings Per Share

• Basic EPS
• Diluted EPS
• Companies required to disclose both Basic EPS and
  Diluted EPS

36
Basic Earnings Per Share

• Earnings per share is
• Computed as
• Net Income less Preferred Dividends
• Weighted Average of Common Shares Outstanding
• Disclosed on the income statement for all the
  major sections.

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Basic Earnings Per Share

• Example
• Assume NI of 5K
• PS Dividends 0
• 12/31/06 year-end
• Outstanding shares as follows
• 1/1/06 100 shares
• 4/1/06 200 shares
• 7/1/06 250 shares
• Weighted Average Calculation

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Earnings Per Share

• At December 31, 2006, Hertz Corporation had the
  following stock outstanding
• 10 cumulative preferred stock, 100 par,
  107,500 shares 10,750,000
• Common stock, 5 par, 4,000,000 shares
  20,000,000
• During 2007, Hertz Corporation did not issue any
  additional common stock. The following also
  occurred during 2007.
• Income from continuing operations before
  taxes 23,650,000
• Discontinued operations (loss before taxes)
  3,225,000
• Preferred dividends declared 1,075,000
• Effective tax rate 35
• Compute EPS as it should appear on the 2007 f/s.

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Retained Earnings Statement

• Retained earnings are increased by net income and
  decreased by net loss and dividends for the year.
• Corrections of errors in prior period financial
  statements are shown as prior period adjustments
  to the beginning balance in retained earnings.
• And changes in accounting policy are treated
  retroactively, so opening R/E is also adjusted
  for the cumulative impact
• Any part of retained earnings, appropriated for a
  specific purpose, is shown as restricted
  earnings.
• These restrictions merely mean you cant pay out
  dividends from restricted R/E (can be part of a
  debt covenant)

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Comprehensive Income

• All changes in equity during a period, except
  those resulting from investments by or
  distributions to owners.
• Includes regular net income
• PLUS other comprehensive income
• unrealized holding gains or losses on securities
• unrealized gains or losses on foreign currency
  translation
• unrealized gains or losses on pension obligations
• (This is discussed in more detail in Chapter 17,
  investments)

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Other Comprehensive Income

• Must be displayed as
• A separate statement of comprehensive income OR
• Combined income statement and comprehensive
  income statement OR
• Part of statement of stockholders equity (most
  companies put it here)

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Other Comprehensive Income

• A L OE
• OE CC RE AOCI
• AOCIend AOCIbeg OCI
• REbeg NI DIV REend
• OE CC REbeg NI - DIV AOCIbeg OCI