1. Prepared by: Patricia Zima, CA Mohawk College of Applied Arts and Technology Chapter 4 Reporting Financial Performance

2. 2 Reporting Financial Performance Income Statement UsefulnessUsefulness LimitationsLimitations Quality of earningsQuality of earnings Reporting Irregular Items Discontinued operationsDiscontinued operations Extraordinary itemsExtraordinary items Unusual gains and lossesUnusual gains and losses Changes in estimatesChanges in estimates Format of the Income Statement ElementsElements Single-stepSingle-step Multiple-stepMultiple-step Intermediate componentsIntermediate components Condensed income statementCondensed income statement Special Reporting Issues Intraperiod tax allocationIntraperiod tax allocation Earnings per shareEarnings per share Retained earningsRetained earningsstatement Comprehensive incomeComprehensive income PerspectivesPerspectives InternationalInternational Appendix 4A – Cash Basis vs. Accrual Basis Earnings Differences between cash and accrual basisDifferences between cash and accrual basis Conversion from cash to accrual basisConversion from cash to accrual basis Theoretical weaknesses of cash basisTheoretical weaknesses of cash basis

3. 3 Financial Reporting Business Model identifies three activities: 1.Financing Obtaining cash funding 2.Investing Use of funding to obtain resources 3.Operating Use of resources to generate profits Financial statements should capture these fundamental business activities

4. 4 Financial Reporting 1.Balance Sheet Reports financing and investing activities 2.Income Statement Reports operating and performance related activities 3.Statement of Cash Flows Reports interrelationship between all three activities

5. 5 Uses and Limitations of the Income Statement Uses: Evaluate past performance and profitability Assist in predicting future performance Assess potential risk or uncertainty in achieving future cash flows Limitations: Items are excluded if they cannot be measured reliably Amounts reported are affected by accounting methods used Use of estimates in measuring income

6. 6 Quality of Earnings The reliability of the information presented is dependent on the quality of earnings Characteristics of high quality earnings: 1.Nature of Content Unbiased and determined objectively Represents economic reality Reflects earnings from ongoing operations Can be correlated with cash flows from operations Based on sound business strategy/model Presentation Does not disguise or mislead (transparent) Information presented is understandable Also, information is clear and concise

7. 7 Presents only two groupings before Income before Discontinued Operations and Extraordinary Items: 1.Revenues (includes gains) 2.Expenses (includes losses) Income tax expense often reported separate from expenses as the last line item in determining net income Advantages: –Simplicity –Eliminates classification problems for revenues and expenses Disadvantage: –Operating and non-operating activities reported together Single-Step Income Statement

8. 8 – = Revenues Revenues Net Sales Other Revenues (e.g. Dividend, Rental) Expenses Expenses Cost of Goods Sold Selling Expenses Administrative Expenses Interest Expense Income Tax Expense Net Income Any Gains/Losses from Discontinued Operations or Extraordinary Items must be disclosed separately from Continuing Operations Earnings per Share Single-Step Income Statement

9. 9 Multiple-Step Income Statement Operating and non-operating activities are separated Expenses are classified by function (e.g. Selling and Administrative Expenses, Cost of Goods Sold) Advantages: Highlighting regular and irregular activities allows for greater predictive value (assess future earnings) and feedback value (assess past earnings) Provides better detail to compare companies Allows for ratio analysis used to assess performance

10. 10 Continuing Operations Operating sectionOperating section Nonoperating sectionNonoperating section Income taxIncome tax Discontinued Operations Income/Loss from operationsIncome/Loss from operations Gain/Loss from dispositionGain/Loss from disposition Both reported net of taxesBoth reported net of taxes Extraordinary Items Material gains/lossesMaterial gains/losses Reported net of taxesReported net of taxes Multiple-Step Income Statement Other Comprehensive Income Includes other gains/losses not included in net incomeIncludes other gains/losses not included in net income

11. 11 Operating Section Net SalesNet Sales Cost of Goods SoldCost of Goods Sold Selling ExpensesSelling Expenses Administrative or General ExpensesAdministrative or General Expenses Nonoperating Section Other Revenues and GainsOther Revenues and Gains Other Expenses and LossesOther Expenses and Losses Income Tax Separate income tax section on Income from Continuing Operations onlySeparate income tax section on Income from Continuing Operations only Continuing Operations–Detail

12. 12 Condensed Income Statement Expenses are reported on the income statement in group totals Details of the expense groups are included on supplementary schedules Provides the advantage of a concise, understandable income statement An example of tradeoff between understandability and full disclosure Reduces “information overload”

13. 13 Reporting Irregular Items Income measurement currently follows a modified all-inclusive approach Most irregular items included in income except for the following: 1.Prior years’ income errors 2.Retroactive changes in accounting policies The above exceptions are recorded as adjustments (reported net of tax) on the Statement of Retained Earnings

14. 14 Reporting Irregular Items- Discontinued Operations Discontinued operations includes components that have been disposed of or are held for sale Components include: ­ An operating segment- A reporting unit ­ A subsidiary- An asset group A distinction made between: ­ The component’s results of operations ­ Disposal of the component’s assets The key is that the component generates its own cash flows and has its own distinct operations

15. 15 Discontinued Operations- Asset Held for Sale Component is held for sale if the following criteria are met: –Authorized plan to sell exists –Asset available for immediate sale –Active search for a buyer –Sale is probable within a year –Asset is reasonably priced and marketed –Unlikely that plan to sell will change These assets carried at lower of carrying value and fair value (net of cost to sell)

16. 16 Income from continuing operations (net of tax) $xx,xxx Discontinued Operations: Income (Loss) from operations (net of tax) $xx,xxx Income (Loss) from operations (net of tax) $xx,xxx Gain (Loss) on disposal (net of tax) xx,xxx xx,xxx Gain (Loss) on disposal (net of tax) xx,xxx xx,xxx Net Income $xx,xxx Earnings per share from continuing operations $ x Earnings per share from discontinued operations x Earnings per share on net income $ x Discontinued Operations– Statement Presentation

17. 17 Extraordinary Items Presented separately on the income statement (net of tax); generally following discontinued operations Characteristics: –Material amounts –Non-recurring items –Differ significantly from the typical business activities Three qualifying criteria (all three must be met): 1.Infrequent 2.Atypical of normal business activities 3.Not primarily dependent on decisions made by management (or owners)

18. 18 CICA Handbook, Section 3480 specifies that the following gains and losses are not extraordinary items: 1)Losses or loss provisions from bad debts and inventories 2)Foreign exchange gains and losses 3)Contract price adjustments 4)Gains and losses from investment write downs 5)Income tax adjustments 6)Income tax rate or law changes Extraordinary Items

19. 19 Unusual Gains and Losses Include gains and losses that do not qualify as an extraordinary item but are material in amount If they are material, they are disclosed separately on the income statement (before extraordinary items) If they are not material, they are shown with the normal revenues and expenses

20. 20 Changes in Estimates Examples of change in estimates are: change in useful lives and salvage values of capital assets, estimate of bad debts Accounted for in the current period No adjustment is made retroactively (i.e. prior years are not adjusted) If change affects future periods, change is accounted for in those periods as well

21. 21 Intraperiod Tax Allocation Refers to the allocation of income taxes within a fiscal period Certain irregular items on the income statement are reported net of tax Specifically, income tax expense (or benefit) is calculated and presented separately for the following: 1.Income from continuing operations 2.Discontinued operations 3.Extraordinary items

22. 22 Earnings per Share Earnings per share (EPS) considered one of the most significant business indicators Indicates dollars earned per common share; it does not report the dollars paid (or to be paid) per common share EPS based on earnings before discontinued operations and extraordinary items and EPS based on net income must be shown on the face of the income statement EPS based on discontinued operations and EPS based on extraordinary items may be disclosed in the notes to the financial statements-see HB 3500.60 and 3500.61

23. 23 * Preferred dividends are those dividends that have been declared (for non-cumulative) or one year’s fixed dividend amount (for cumulative) Earnings per share is subject to dilution (reduction) if issue of additional shares is possible in the future For such situations, both Basic EPS and Diluted EPS are presented Earnings per Share Weighted Average of Common Shares Outstanding Net Income less Preferred Dividends* Calculated as:

24. 24 Retained Earnings Statement Retained earnings increases by net income and decreases by net loss and declared dividends (both cash and stock dividends) for the year Correction of errors in prior periods and effects to prior periods from accounting policy changes are treated as prior period adjustments They adjust (net of tax) beginning retained earnings; also prior years’ financial statements are often restated Must disclose any part of retained earnings appropriated (restricted) for a specific purpose (e.g. contractual obligation, corporate policy)

25. 25 Comprehensive Income Includes any item that causes a change in equity except for investments by owners and distributions to owners Under all-inclusive income approach, the following items are included as other comprehensive income: –Unrealized gains/losses on available-for-sale securities –Certain translation gains/losses on foreign currency –Unrealized gains/losses on certain hedging transactions

26. 26 Comprehensive Income Separate disclosure of these equity items would: 1.Highlight the impact on net income of fair value fluctuations 2.Inform users of potential gains/losses AcSB disclosure for other comprehensive income items requires: –Expanded income statement or the statement of shareholders’ equity, or adding another statement –Comprehensive EPS not required to be disclosed

27. 27 International Issues The IASB involved in “Financial Statement Presentation” project which consists of three phases: 1.Phase A - What constitutes a complete set of financial statements 2.Phase B - Presentation of information on the face of the statements 3.Phase C - Interim financial reporting

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