The Income Statement and Statement of Cash Flows

1

• The Income Statement and Statement of Cash Flows

2
Objectives of the Chapter

• 1. Study the content of an income statement.
• 2. Study the reporting of comprehensive income.
• 3. Prepare a retained earnings statement.
• 4. Discuss the quality of earnings, earnings
  management and limitations of the income
  statement.
• 5. Study the content of a statement of cash
  flows.

3
Income Measurement

• a. Capital Maintenance Approach
• Income Net assets changes adjusting for
  additional investments from owners and dividends.
• b. Accounting Measurement of Income (transaction
  approach)
• Revenues- Expenses Gains - Losses

4
Definition of Elements of Accounting Income
Measurement

• 1. Revenues inflows or increases of assets or
  decreases of liabilities from activities related
  to the major operation of a business entity will
  eventually increase stockholders equity (i.e.,
  sales revenue).
• .

5
Revenue Recognition Principle (SFAS No. 5) (-An
Accrual Basis)

• Revenue is recognized when it is earned and
  realized or realizable (SFAC 5, par. 83).
• Earned the entity has substantially
  accomplished what it must do to be entitled to
  compensation.
• Realized goods are exchanged for cash or claims.
• Realizable assets received as compensation are
  readily convertible into cash or claims to cash.
• In general, these conditions are met at time of
  sale (delivery) or when services are rendered
  (SFAC 5, par. 84).
• .

6
Revenue Recognition Principle

• Other conditions for revenue recognition (Staff
  Accounting Bulletin No. 101(1999))
• Persuasive evidence of a sale.
• Price is fixed or determinable.
• Collectibility is reasonably assured.
• Delivery has occurred or services have been
  rendered.

7
Definition of Elements of Accounting Income
Measurement (contd.)

• 2. Expenses outflows or decreases of assets or
  increases of liabilities of a business entity
  from activities related to the major operation of
  a business entity will eventually decrease
  stockholders equity.
• Recognition Principle Expense recognition (or
  matching) principle.

8
The Expense Recognition (Matching) Principle

• If revenues are recognized in a period, all
  related expenses should be recognized in the same
  period regardless whether expenses are paid or
  not.
• The related expenses include traceable costs
  (e.g. product costs), period costs, (e.g.
  interest and rent expenses) and estimated
  expenses (e.g. depreciation expense and bad debt
  expense).

9
Definition of Elements of Accounting Income
Measurement (contd.)

• 3. Gains increase in assets from incidental
  transactions (not related to the major operation
  of a business entity).
• 4. Losses decrease in assets from incidental
  transactions.
• (i.e., Losses from sale of equipment, inventory
  write-off, unrealized losses of marketable
  security valuation)

10
What Should Be Included (Reported) in The Income
Statement?

• Two concepts
• Items under debate

11
Two Concepts

• a. Current Operating Performance Concept
• I/S should only include normal, ordinary,
  recurring results of operations from the current
  period.
• b. All-Inclusive Concept
• All transactions should be reported in I/S
  (except for dividends distribution and capital
  transactions).

12
Irregular Items under Debate

• 1. Results from Discontinued Operations.
• 2. Extraordinary Items.
• 3. Unusual Gains or Losses (i.e., losses from
  inventory write-off, losses or gains from
  disposal of PPE, foreign currency translation
  gains or losses etc.).
• 4. Corrections of errors of prior years (Prior
  Period Adjustments).
• 5. Accounting Changes (i.e., changes in estimates
  and changes in accounting principles).

13
Numbers of Irregular Items Reported in Recent
Years by 500 Large Companies (Source Kieso,
etc., 14th e, illustration 4-5)
14
Irregular Items under Debate

• APB opinion No. 9 (effective 12/31/66) adopts the
  all inclusive concept except for the prior period
  adjustment , dividends and capital adjustments
  (thus, a modified all inclusive concept).
• SFAS No. 154 further excludes the reporting of
  the cumulated effect from changes of accounting
  principles from the income statement.

15
Exhibit 4-1 Multiple-Step Income Statement
BANNER CORPORATION Income Statement For Year
Ended December 31, 20x2 Sales revenue 150,000 L
ess Sales returns and allow. 4,000 Sales
discounts taken 2,300 (6,300) Net
sales 143,700 Cost of goods sold (Note A)
(86,000) Gross profit 57,700 Operating
expenses Selling expenses (Note
B) 10,200 General and administrative exp.
(Note C) 16,000 Depreciation
expense 7,800
15
16
Exhibit 4-1 (contd.)
Depreciation expense 7,800 Total operating
expenses (34,000) Operating income 23,700
Other revenues and expenses Interest
revenue 1,800 Dividend revenue 600 Interest
expense (2,100) Loss on sale of equipment
(4,000) (3,700) Pretax income from
continuing operations 20,000 Income tax
expense (6,000) Income from continuing
operations 14,000
16
17
Exhibit 4-1 (contd.)
Income from continuing operations 14,000 Result
s from discontinued operations Income from
operations of discontinued component A
(net of 1,950 I/T) 4,550 Loss on disposal of
component A (net of 3,150 I/T credit)
(7,350) (2,800) Income bef. extraordinary
items 11,200 Extraordinary loss from
explosion (net of 750 I/T credit) (1,750) Net
income 9,450
17
18
Exhibit 4-1 (contd.)
Earnings Per Share Components of
Income (5,000 shares) Income
from continuing operations 2.80 Results from
discontinued operations (0.56) Extraordinary loss
from explosion (0.35) Net income 1.89
Basic and Diluted EPS
18
19
Note A Cost of Goods Sold

• Inventory, 1/1/x2 40,000
• Purchases 120,000
• Less Purchase discounts (5,000)
• Freight-In 10,000
• Net purchases 125,000
• Total inv. available for sale 165,000
• Less inventory, 12/31/x2 (79,000)
• Cost of goods sold 86,000

20
Note B Selling Expenses

• Sales salaries and commissions 3,000
• Sales office salaries 2,000
• Travel and entertainment 1,000
• Advertising expenses 1,000
• Freight-out 800
• Shipping supplies and expenses 1,700
• Postage and stationery 400
• Telephone telegraph expenses 10,200

21
Note C General and Administrative Expenses

• Offices salaries 10,000
• Legal and professional services 2,000
• Utility expense 2,000
• Insurance expense 1,000
• Stationery, supplies and postage 500
• Miscellaneous office expense 500
• 16,000

22
Exhibit 4-2 Single-Step Income Statement
BANNER CORPORATION Income Statement For Year
Ended December 31, 20x2 Revenues Sales rev. (net
of 2,300 discounts and 4,000 returns
and allow.) 143,700 Interest revenue 1,800 Divi
dend revenue 600 Total
revenues 146,100 Expenses Cost of goods sold
(Note A) 86,000 Selling expenses (Note
B) 10,200 General and administrative
expenses. (Note C) 16,000
22
23
Exhibit 4-2 (contd.)
General and administrative expenses. (Note
C) 16,000 Depreciation expense 7,800 Loss on
sale of equipment 4,000 Interest
expense 2,100 Income tax expense
6,000 Total expenses (132,100) Income from
continuing operations 14,000 Results form
discontinued operations Income from operations
of discontinued component A (net of
1,950 I/T) 4,550 Loss on disposal of component
A (net of 3,150 I/T credit) (7,350)
(2,800)
23
24
Exhibit 4-2 (contd.)
Loss on disposal of component A (net of
3,150 I/T credit) (7,350) (2,800) Income bef.
extraordinary items 11,200 Extraordinary loss
from explosion (net of 750 I/T
credit) (1,750) Net income 9,450
24
25
Exhibit 4-2 (contd.)
Earnings Per Share Components of
Income (5,000 shares) Income from
continuing operations 2.80 Results from
discontinued operations (0.56) Extraordinary loss
from explosion (0.35) Net income 1.89
Basic and Diluted EPS
25
26
Another Example of An Income Statement(Kieso,
etc.,illustration 4-17) ssss
27
Four Parts of the Income Statement

• I. Income from continuing operations.
• a. Net sales.
• b. CGS.
• c. Operating expenses
• d. Other revenue and expenses (including unusual
  gains losses).
• e. Income taxes for the continuing operations.

28
Four Parts of the Income Statement (contd.)

• II. Results from discontinued operations (net of
  I/T).
• a. Income (Losses) from operations of
  discontinued components.
• b. Gains (Losses) from disposal of discontinued
  components.
• III. Extraordinary items (net of I/T).

29
Four Parts of the Income Statement (contd.)

• IV. Earnings per share (by components).
• Prior period adjustments are reported in the
  statement of retained earnings at the net of I/T
  effect.

30
I. Income From Continuing Operations Details

• a. Net sales
• Sales -Sales RA - sales Discounts
• b. C.G.S. (see Note A)
• Perpetual Inventory system.
• Periodic Inventory system.
• CGS Beginning Inventory Net Purchases -
  Ending Inventory
• Net Purchases Purchases - Purchases RA -
  Purchases Discounts Freight-In

31
I. Income From Continuing Operations (contd.)

• c. Operating expenses (see Ciena Corp. annual
  report of 2008) Cost incurred to generate
  operations including
• Research and Development
• Selling Expense (see Note B)
• Administrative Expense (see Note C)
• Depreciation and amortization Exp.
• Restructuring costs
• Goodwill and long-lived asset impairments

32
I. Income From Continuing Operations (contd.)

• d. Other revenues and expenses (including unusual
  gains and losses)
• Revenues and expenses of recurring items that are
  not related to major operations (i.e. interest
  revenue and expense, etc.)
• Gains and losses that are unusual but not
  infrequent loss from inventory write-off, gains
  or losses from disposals of PPE or sale of
  investments, gains or losses from foreign
  currency translation.

33
I. Income From Continuing Operations (contd.)

• e. Income taxes related to continuing operations
  (an example of an intra-period income tax
  allocation).

34
I. Income From Continuing Operations
(contd.)-Restructuring Costs

• Restructuring Costs costs associated with
  reorganization (i.e., closing down facilities) of
  operations.
• Examples relocation costs, severance pays (due
  to facility closings), loss from assets
  write-down, etc.

35
Restructuring Costs (Contd.)

• Potential benefits from restructuring greater
  operational efficiency in the future.
• Accounting treatments of restructuring costs
• Prior to SFAS 146 estimated the costs and
  recognized them in the period in which the reorg.
  decision was made.

36
Restructuring Costs (contd.)

• Problems associated with this treatment
• Premature restructuring expense/liability
  recognition.
• Violating the matching principle.
• Subject to income manipulation.

37
Restructuring Costs (contd.)

• SFAS 146 managers can only recognize
  restructuring costs (i.e., expense/liability)
  when a liability actually has happened.
• SFAS 146 alleviates the income manipulation
  problem associated with the recognition of
  restructuring costs.
• SFAS 146 promotes the matching principle.

38
Format of Income From Continuing Operations and
Earnings Quality

• Format of income from continuing operations
• Single-step (Exhibit 4-2)
• Multiple-step (Exhibit 4-1) Subdivide the
  continuing operations results into subgroups
  based on the characteristics of operating
  revenues and expenses (i.e., sustainable vs.
  transitory such as restructuring costs,
  impairment charges ).

39
Format and Earnings Quality (source Spiceland,
etc.)

• The relevance of a historical financial statement
  hinges on its predictive value.
• Earnings quality is referred to the ability of
  reported earnings to predict a companys future
  earnings.
• To enhance the earnings quality, transitory
  earnings should be separated from the permanent
  earnings.
• The multi-step format can enhance the earnings
  quality.

40
Nonoperating Income and Earnings Quality (source
Spiceland, etc.)

• Items such as interest revenues, gains and losses
  from disposal of PPE or investments are referred
  to nonoperating items.
• For some companies, these nonoperating items may
  contribute significantly to their earnings
  (i.e., Intel- gains from investments contribute
  24.8 to its 2000 pre-tax income, etc.).

41
Pro Forma Earnings (Source Spiceland, etc.)

• Companies often voluntarily report pro-forma
  earnings to present managers view of permanent
  earnings.
• Sun Microsystems, Inc. reported 67 million
  earnings for the quarter ended April 1, 2007 but
  reported pro forma earnings of more than twice of
  its GAAP income.

42
Pro Forma Earnings (Source Spiceland, etc.)

• Sun Microsystems pro forma earnings exclude
  stock-based compensation, restructuring and
  impairment charges, intangible asset amortization
  charges, gains from sale of equity investment and
  litigation settlement income.
• The Sarbanes-Oxley Act requires the reporting of
  pro forma earnings to provide a reconciliation
  with GAAP earnings.

43
Pro Forma Earnings versus Earnings from
Operations (Kieso, etc. 14th e, p158)
44
II. Reporting Results From Discontinued
Operations

• What Constitutes an Operation?
• APB No. 30 defines an operation as a segment of a
  business (i.e., a separate line of business or a
  separate class of customer).
• SFAS 144 (issued in 2001) replaced the term
  segment of a business with component of an
  entity.

45
Definition and Examples of Component of An
Entity

• A component of an entity comprises operations
  and cash flows that can be clearly distinguished,
  operationally and for financial reporting
  purposes, from the rest of the entity (SFAS 144
  , pa. 41).
• Examples of a component (SFAS 144, pa41) a
  reportable segment, an operating segment, a
  reporting unit, a subsidiary or an asset group.

46
When to Report Results of Discontinued Operation?

• If a component of a business has either been
  disposed of or classified as held for sale, the
  results of the component should be reported
  separately in discontinued operations if two
  conditions are met
• 1. The operations and cash flows of the component
  have been (or will be) eliminated from the
  ongoing operations of the entity, and
• 2. The entity will not have significant
  continuing involvement in the operations of the
  component after the disposal transaction.

47
Definition and Examples of Component of An
Entity (Skip)

• An operating segment a component
• engages in business activities which generating
  revenues and incurring expenses,
• with discrete financial information available
  and
• managers regularly review its operating results
  to make decisions (SFAS 131, pa. 10).

48
Definition and Examples of Component of An
Entity (contd.) (Skip)

• A reporting unit
• an operating segment or a level below it as long
  as discrete financial information is available
  and managers regularly review the information
  (SFAS 142, pa. 30)
• An asset group
• a group of assets represents the lowest level
  for which the cash flows are largely independent
  of the cash flows of other groups (SFAS 144, pa.
  4).

49
Reporting Elements of the Results of Discontinued
Operations (SFAS 144)

• Case I Disposal date is on or before the fiscal
  year end (FYE) date
• The reporting elements include
• operating income (or loss) of the discontinued
  component from the beginning of the reporting
  period to the disposal date (net of tax), and
• disposal gain (or loss) on the disposal of the
  component (net of tax).

50
Reporting Elements (contd.)

• Case II Expected disposal date is after the FYE
  date
• The reporting elements include
• Operating income (or loss) of the discontinued
  component from the beginning of the reporting
  period to the FYE date(net of tax),
• An impairment loss if the fair value (minus costs
  to sell) of the assets of the component is less
  than the book value.

51
Reporting Elements (contd.)

• These two elements can be combined or reported
  separated.
• If combined, the disposal gain or loss must be
  disclosed.

52
Case I Disposal Date Is Before or on the Fiscal
Year End Date

• 1/1/x3 7/1/x3 11/30/x3 12/31/x3
• Phase-out period
• Realized pretax op. income (1/1/x3 -7/1/x3)
  8,000
• Realized pretax op. income (7/1/x3 -
  11/30/x3) 2,000
• Realized disposal loss (7/1/x3 -
  11/30/x3) (12,000)
• A division has been disposed of and the
  information pertaining this disposal is provided
  above. The operations and cash flows of this
  division can be clearly distinguished from the
  rest of the entity.

53
Case I (contd.)

• Results from discontinued operations
• Income from operations of
• discontinued component X,
• less applicable I/T of 3,000 7,000
• Loss on disposal of component X,
• less applicable I/T savings of 3,600 (8,400)
• (1,400)
• Assume a 30 tax rate.

54
Case I (contd.)

• Disclosure
• 1. The identity of the component of business that
  has been or will be discontinued.
• 2. The major classes of assets and liabilities of
  the component.
• 3. The expected manner of disposition.
• 4. The reason of discontinuance.

55
Case II Expected Disposal Date is after the
FYE Date

• Measurement Date FYE
  Expected Disposal Date
• 1/1/x3 8/1/x3 12/31/x3 5/1/x4
• Phase-out period
• Realized operating income
• (1/1/x3 -12/31/x3) 25,000
• Impairment loss on assets (22,000)
• Note1 Assets book value on 12/31/x3,70,000
  assets fair value on 12/31/x3 minus expected
  costs to sell,48,000.
• Note 2 Any realized disposal gains or losses
  should also be recognized and reported.

56
Case II (contd.)

• Results from discontinued operations
• Income from operation of component X,
• net of applicable I/T of 7,500 17,500
• Impairment loss of component X ,
• net of I/T savings 6,600 (15,400)
• 2,100
• Assume a 30 tax rate.

57
Case II (continued)

• Reporting the held for sale asset of the
  discontinued component on the balance sheet
• The asset should be reported at the lower of the
  book value or the fair value minus costs to sell.
• The asset is reported under other assets and is
  not subjected to depreciation or amortization.

58
III. Extraordinary Items

• Must meet three criteria (APB opinion 30)
• 1. Unusual in nature.
• 2. Infrequent in occurrence.
• 3. Material in amount.
• Note iGAAP prohibits extraordinary item
  reporting (Source KWW Convergence Corner, p155).

59
Examples

• Direct result of a major casualty (i.e., flood,
  earthquake.).
• Expropriation by a foreign government.
• Prohibition under a newly enacted law.

60
Examples (contd.)

• Not extraordinary Items
• 1. Write-off of A/R, N/R, inventories, equipment.
• 2. Gains or losses from foreign currency
  exchanges.
• 3. Gains or losses from disposal of a component.
• 4. Gains or losses form sale of P.P.E. used in
  operation.
• 5. Effects of strikes.
• 6. Adjustments of accruals on long-term
  construction contract.

61
Other Examples (contd.)

• Not Extraordinary Items
• Selling a block of shares from investment
  portfolio.
• Selling a piece of land (occurred a few times
  before).
• Frost damage on citrus in Florida.
• Hurricane loss for business in the Gulf Coast.

62
IV. Earnings Per Share

• Basic Diluted
• EPS EPS
• Continuing operations xx xx
• Discontinued operations xx xx
• Extraordinary Items xx xx
• Total xx xx
• EPS Net Income - Preferred Dividends
  
• Weighted Average of Common Share Outstanding

63
IFRS (Source KWW IFRS Insights, 14th edition)

• IFRS does not mention single or multiple-step
  format.
• IFRS prohibits the reporting of extraordinary
  items.
• IFRS and GAAP follows the same presentation
  guidelines for discontinued operations but differ
  in defining a discontinued operations.

64
IFRS (Source KWW IFRS Insights, 14th edition)

• IFRS requires company to indicate the amount of
  net income attributable to non-controlling
  interest.
• IFRS allows the revaluation of land, buildings
  and intangibles. The unrealized losses/gains are
  reported as comprehensive income items in the
  equity section of the B/S.

65
Accounting Changes (based on SFAS 154)

• Changes in Accounting Estimates Revision of an
  estimate due to new information or new
  experience.
• Changes in Accounting Principle Change from one
  GAAP method to another GAAP method.
• Changes in Reporting Entity Reporting financial
  statements for an entity other than the entity
  existed in the previous period.

66
Accounting Changes (contd.)

• Accounting treatments for accounting
  changes(SFAS 154)
• 1. Changes in Accounting Estimates-prospective
  treatment.
• 2. Changes in Accounting Principle- retrospective
  treatment.
• 3. Changes in Reporting Entity- restating
  financial statements of all prior periods of the
  new reporting entity.

67
Changes in Accounting Estimates

• Examples
• Changes in the estimated life of property, plant
  and equipment.
• Change in the bad debt estimation.
• Depreciation method change is now considered as
  an estimate change under SFAS 154.

68
Changes in Accounting Estimates(cont.)-Prospective
Approach

• Accounting Treatment Prospective approach.
• Do not restate prior statements using the new
  estimates. Simply apply the new estimates to the
  current and subsequent years.
• Footnote disclosure required.

69
Changes in Accounting Estimates Examples
(Prospective Treatment)

• A. Change the bad debt exp. estimation from 2 to
  4 of the net sale in 20x6. The net sale of 20x6
  amounts to 50,000.
• 12/31/x6 Bad debt exp. 2,000
• Allow. for bad debt 2,000
• Note Due to the accounting estimate change, the
  bad debt expense is increased from 1,000 (at 2)
  to 2,000 (at 4). The net impact (net of income
  tax credit) from this change is a 700 decrease
  in net income of 20x6.

70
Changes in Accounting Estimates Examples
(contd.) (skip p71-75)

• B. Machine costing 15,000 was purchased on
  1/1/x4 with estimated life of 5 years and zero
  residual value. The straight-line method was
  used for depreciation. On 1/1/x6, the estimated
  life of the machine had been changed to 6 years
  and the residual value had been changed to 1,000
  due to new information available.
• Book value of the machine on 1/1/x6
• (15,000-6000) 9,000
• Depreciation expense for 20x6, 20x7,20x8, and
  20x9
• (9,000 -1,000) / (6-2) 2,000

71
Example B of Changes in Accounting Estimates
(contd.)

• 12/31/x6
• Depr. Exp. 2,000
• Acc. Depr. 2,000
• Note Due to the accounting estimate changes on
  the estimated life and the salvage value of
  machine purchased on 1/1/x6, the depreciation
  expense of 20x6 is decreased by 1,000. The net
  of income tax effect is a 700 increase in net
  income of 20x6.

72
Example C Depreciation Method Change Is Treated
as an Estimate Change under SFAS 154

• The Gate Inc. decided to change from the
  straight-line depreciation method to the
  sum-of-the-years-digits method at the beginning
  of year x5 for a plant asset. This plant asset
  was purchased at the beginning of x2 at a cost of
  15,000, with an estimated life of 5 years and no
  salvage value.
• The new depre. Expense is
• 20x5 gt (15,000-9,000)6,000
• 6,000x2/34,000 and
• 20x6gt 6,000x1/3 2,000.

73
Example C (contd.)

• 2005 Note Due to the accounting method changes
  from the straight-line depreciation method to the
  sum-of-the-years-digits method at the beginning
  of year x5, the depreciation expense of 20x5 is
  increased by 1,000. The net of income tax
  effect is a 700 decrease in net income of 20x5.

74
Changes in Accounting Principle

• a. Current Period Approach (APB 20, Old)
• Reporting the cumulative effect (net of income
  taxes) as a separate item following extraordinary
  items in the I/S (not allowed under SFAS 154).

75
Accounting Change in Principle (cont.)

• b. Retrospective Approach (SFAS 154) Restate
  financial statements of the prior periods
  presented as if the new accounting method were
  applied, and
• Report the cumulative effect of those years not
  restated in the statement of retained earnings.

76
Changes in Accounting Principle (contd.)

• SFAS 154 requires voluntary accounting changes be
  accounted for retrospectively unless the
  retrospective application is impracticable.
• For a newly issued standard, the provisions of
  the standard shall be followed.

77
Changes in Accounting Principle (contd.)

• If no specific transition provisions were
  prescribed, a retrospective approach should be
  applied.
• The elimination of the current period approach in
  SFAS 154 is to improve the comparability and to
  be convergent with the IAS.

78
Changes in Accounting Principle (contd.) (skip)

• Retrospective application of the new standard is
  Impracticable when
• The effects of the retro. application are not
  determinable.
• The application requires assumptions regarding
  managers intent in a prior period.
• The application requires sig. estimates of a
  prior period and it is not clear whether
  information to develop those estimates would have
  been available in prior periods.

79
Accounting Principle Change

• An example of voluntary accounting method change
  (i.e., change from LIFO to FIFO or from the
  percentage-of-completion method to
  completed-contract method for a long-term
  construction project) using the retrospective
  approach will be illustrated in chapter 22.

80
Changes in Reporting Entity

• Restate the financial statements of all prior
  years presented to show financial information for
  the new reporting entity for all periods.

81
Other Items Related to Income Statement Reporting

• 1. Condensed Income Statement (Example I/S of an
  annual report).
• 2. Interim Reports quarterly reports are
  required by the SEC for publicly traded companies
  (10-Q report). Reporting guidelines are provided
  in APB 28.
• 3.
• Segment Reporting (SFAS 131).
• Foreign operations and export sales reporting.
• Major customers.

82
Other Items Related to Income Statement
Reporting (contd.)

• 4. Related Party Transactions (FASB No. 57).
  (sales, transfer of properties, purchases,
  services, )
• 5. Accounting procedures (APB 22).
• Inventory cost flow assumption.
• Depreciation, amortization method.
• Revenue recognition principle.
• Interest capitalization.

83
Comprehensive Income (SFAS No. 130)

• The change in equity excluding owner related
  transactions such as investments from owners and
  dividends distribution.

84
Comprehensive Income (SFAS No. 130) (contd.)

• Components of comprehensive income
• a. Net income (as reported in the I/S)
• b. Other comprehensive income items
• These gains and losses are not reported in the
  I/S, but in the stockholders section of a B/S.
  They bypass the I/S but affect stockholders
  equity.

85
Comprehensive Income (SFAS No. 130) (contd.)

• Other comprehensive income items
• Unrealized gains (losses) from valuation of
  investments,
• Deferred gains(losses) from derivatives,
• Gains (losses) of foreign currency translation
  adjustments, and
• Gains (losses) from amendments to pension plans.
• iGAAP allows revaluations of land, buildings and
  intangible assets. This practice results in more
  comprehensive income items (Source KWW, IFRS
  Insights)

86
Presentation of Net Income and Other
Comprehensive Income Items

• Comprehensive Income Items Presentation format
• A. The two income statement format.
• B. Combined income statement format.
• C. Statement of stockholders equity format
  (Eliminated by ASU 2011-05) .
• IFRS allows formats A and B, not C.
• Accounting Trends and Techniques 2010 survey
  indicates that 492 of the 500 companies surveyed
  report comprehensive income.
• 400 of the 492 companies use format C.

87
Presentation of Net Income and Other
Comprehensive Income Items An Example

• Example Assuming Avon Corp. reports net sales of
  1,000,000 CGS of 500,000, operating expenses of
  100,000 and an unrealized loss on
  available-for-sale securities of 40,000 (net of
  tax) for year 20x1.

88
A. The Two Income Statement Format

• Avon Corp.
• Income Statement
• For the Year Ended 12/31/x1
  
• Sales Revenue (Net) 1,000,000
• CGS 500,000
• Gross Profit 500,000
• Operating Expenses 100,000
• Net Income 400,000

89
A. The Two Income Statement Format (contd.)

• Avon Corp.
• Comprehensive Income Statement
• For the Year Ended 12/31/x1
  
• Net Income 400,000
• Other Comprehensive Income Items
• Unrealized Loss, net of tax 40,000
• Comprehensive Income 360,000

90
B. Combined Income Statement Format

• Avon Corp.
• Combined Statement of Comprehensive Income
• For the Year Ended 12/31/x1
  
• Sales Revenue 1,000,000
• CGS 500,000
• Gross Profit 500,000
• Operating Expenses 100,000
• Net Income 400,000
• Unrealized Loss, net of tax 40,000
• Comprehensive Income 360,000

91
C. Statement of Stockholders Equity Format (most
commonly used format in the US eliminated by ASU
2011-05, effective date is for fiscal years
beginning after 12/15/2011 with early adoption
permitted)

• Other information available for the statement
• Beginning balance of common stock, 500,000,
  retained earnings, 600,000 and accumulated other
  comprehensive income, 150,000. No changes in
  the common stock account during 20x1. A
  statement of stockholders equity is as follows

92
C. Statement of Stockholders Equity Format
(contd.)

• Accum.
• Other
• Comprehensive Retained Compre. Comm.
  
• Income Earnings Income
  Stock Total
• Beg. Balance 0 600,000 150,000 500,000 1,250,000
  
• Compre. Income
• Net Income 400,000 400,000 400,000
• Other Compre.
• Income
• Unrealized Loss (40,000) (40,000) (40,000)
• Compre. Income 360,000
  
• Ending Balance 1,000,000 110,000 500,000 1,610,00
  0

93
Balance Sheet Presentation

• Avon Corp.
• Balance Sheet Statement
• as of 12/31/x1
• (Stockholders Equity Section)
  
• Stockholders Equity
• Common Stock 500,000
• Retained Earnings 1,000,000
• Acc. Other Compre. Income 110,000
• Total Stockholders Equity 1,610,000

94
Statement of Retained Earnings

• Reporting Items
• N/I
• Dividends (cash stock)
• Prior-period adjustment (Net of I/T)

95
Exhibit 4-3 (Kieso, etc., 14th edition,
illustration 4-18)

• Justin Rose, Inc.
• Retained Earnings Statement
• For the Year Ended December 31, 2012
• Balance, January 1, as reported 1,050,000
• Correction for understatement of net income
• in prior period-inventory error (net of tax)
  50,000
• Balance, January 1, as adjusted 1,100,000
• Add Net income 360,000
• 1,460,000
• Less Cash dividends 100,000
• Stock dividends 200,000 300,000
• Balance, December 31 1,160,000

96
Earnings Quality

• Predictive value is a component of the relevance,
  a primary quality of accounting information.
• Earnings quality refers to the ability of
  reported earnings to predict future earnings.
• Earnings management reduces earnings quality.

97
Earnings Quality (Contd.)

• Transitory versus Permanent Earnings
• Transitory earnings (with lower earnings quality
  than permanent earnings) results from
  transactions or events that are not likely to
  occur again in the foreseeable future or are
  likely to have a different impact on the earnings
  in the future.

98
Earnings Quality (Contd.)

• Examples of results of transitory transactions or
  events
• Restructuring costs.
• One-time charges other than restructuring costs.
• Gains from sale of investments or PPE.
• Results from the discontinued operations.
• Extraordinary gains or losses.

99
Defining Earnings Management

• The practice by which earnings reported reflect
  the desires of management rather than the
  underlying financial performance of the firm.
  (Arthur Levitt, the former SEC chairman) or
• The planned timing of revenues, expenses, gains
  and losses to smooth out bumps in earnings.
  (KWW, p161)
• Example Prematurely recognized sales revenue to
  increase earnings at the expense of income in
  future years (KWW, p161)

100
Why Can Earnings Be Managed?

• Determining when revenue has been earned
  (critical event) and is realized
  (measurability)the two revenue recognition
  conditionsoften requires management judgment.

101
Why Can Earnings Be Managed?

• Managers can sometimes exploit the flexibility in
  GAAP(i.e. the choice of accounting methods and
  estimates) to manipulate reported earnings in
  ways that mask the companys underlying
  performance.
• Some managers have achieved earnings management
  by financial frauds (thats illegal).

102
Popular Earnings Management Devices

• Big bath of restructuring charges Excessive
  restructuring write-offs that overstate estimated
  charges for future expenditures (curtailed by
  SFAS 146).
• Creative acquisition accounting Abuses linked to
  purchased in-process RD that SFAS No. 2
  requires to be expensed at the date of
  acquisition.

103
Popular Earnings Management Devices

• Miscellaneous cookie jar reserves for bad
  debts, loan losses, warranties and other
  accruals A convenient income smoothing device.
• Intentional errors deemed to be immaterial and
  intentional bias in estimates.

104
Popular Earnings Management Devices (contd.)

• Income shifting including
• Premature or aggressive revenue recognition
  (i.e., Delphi, General Mills, and Lucent
  Technology)
• Delay recognition of expenses (i.e., WorldCom and
  AOL).

105
Premature Recognition of Revenue

• Delphi (WSJ, 3/7/2005) 1)Prematurely recognized
  revenue for tech contracts 2) boosted cash
  flows and earnings by selling assets and
  inventory with buy back agreements.
• General Mills (WSJ 2/18/04) Parking
  transactions.
• Lucent Technology (Spiceland, etc. 5th edition)
  Improperly recognized sales of 1.15 billion in
  2000 with false documents..

106
Premature Recognition of Revenue (contd.)

• Bristal-Myers Squibb (WSJ 6/6/2005)
• Sales was inflated by 2.5 billion from
  1999-2001.
• Wholesalers of Bristal-Myers Squibb were offered
  incentive to buy more products than needed at the
  end of fiscal quarters (this practice is referred
  as parking transaction).

107
Delay Recognition of Expenses

• Traceable costs cannot be managed easily except
  in the adoption of different cost flow
  assumptions.
• Period costs may be subject to earnings
  management or frauds.
• AOL delayed recognition of advertising expenses
  in 1995, 1996 and WorldComs improper
  capitalization of its line costs of 3.8 billion
  in 2000-01.

108
Earnings Management of Allocation Costs

• Allocation Costs (i.e., depreciation expense)
• May be subject to earnings management due to
  GAAPs flexibility in allocation methods.
• The estimation of expenses is subject to
  managers discretion.

109
Revenue Recognition AbusesSAB No. 104 examples
SEC SAB No.104 illustrates troublesome areas of
revenue recognition. 1.Goods shipped on
consignment No revenue can be recognized at
delivery. 2. Sales with delayed delivery
Seller cannot recognize revenue until
delivery. 3. Goods sold on layaway Postpone
revenue recognition until merchandise is
delivered to customer.
110
Revenue recognition abusesSAB No. 104 examples
4. Non refundable up-front fees Earned as
services are delivered over the full term of
service engagement. 5. Gross vs. net basis for
internet resellers Revenue should be recognized
on a net basis as commission revenue. 6.
Capacity swaps Revenue should be recognized
over time as the capacity is bought on line and
used by customers.
111
The Importance of Reporting Transparency and the
Understanding of Events Reported

• With the flexibility in reporting, the
  transparency in reporting is essential to the
  understanding of the information reported.
• In order to predict earnings, one must understand
  the events reported in the income statement and
  their relationship with future earnings (i.e.,
  sustainable or transitory) (Spiceland, etc.).

112
Techniques to Adjust Net Income to Relevant Net
Income

• 1. Nature of Accounting Policies.
• 2. Discretionary Costs.
• 3. Degree of Certainty of Accounting Estimates.
• 4. Maintenance of Capital.
• 5. Stability of Earnings.
• 6. Off-balance Sheet Liabilities.

113
The Usefulness of the Income Statement (Kieso,
etc. 14th e, p160)

• Evaluation the past performances of the company
• Provide a basis for predicting future performance
• Help assess the risk or uncertainty of achieving
  future cash flows

114
The Limitations of the Income Statement

• Income measurement is based on principles such
  as historical cost principle assets are mostly
  reported at cost, thus, the unrealized gains or
  losses on assets are not recognized.
• For investments reported at market value, the
  unrealized gains/losses of some are reported only
  in the balance sheet statement.

115
The Limitations of the Income Statement (contd.)

• Income is based on many estimates which are
  discretionary and require judgments.
• Income is affected by the choice of accounting
  methods.
• Income can be manipulated by managers.
• Off balance sheet liability (thus, off I/S
  expense).

116
Statement of Cash Flows

• Statement of Cash Flows
• Providing uses and sources of cash and operating,
  financing and investing information of a business
  entity.

117
Statement of Cash Flows (SFAS No. 95)

• Three Sections
• 1. Cash flows from operating activities
• N/I Adjustments (i.e., depreciation,
  amortization),
• any increase in current liabilities,
• any decrease in current assets (except cash and
  notes receivable),
• - any decrease in C.L.,
• - any increase in C.A. (except cash and notes
  receivable).

118
Statement of Cash Flows (SFAS No. 95) (contd.)

• 2. Cash flows from investing activities (inflows
  and outflows).
• 3. Cash flows from financing activities (inflows
  outflows).

119
GREEN CompanyStatement of Cash Flows For the
Year Ended December 31, 2012

• Net cash flows from operating activities
• Net Income
  8,400
• Adj. To reconcile net income to net
• cash provided by operating activities
• Add Depreciation Expense 3,400
• Decrease in A/P 800
• Increase in S/P 400
• Less Increase in Inventory
  (1,600)
• Decrease in A/P
  (1,900)
• Gain on sale of Equipment (600)
• Net cash provided by oper. activities
  8,900

120
GREEN Company Statement of Cash Flows (contd.)
121
GREEN Company Statement of Cash Flows (contd.)
122
Green CompanyStatement of Cash Flows

• (Using the direct method in preparing the
  operating activities section of a cash flow
  statement. Information as provided in the
  previous example)
• Cash flows from Operating Activities
• Cash inflows
• Collections from customers 80,800 1
• Cash inflows from
• operating activities 80,800
• 1. 80,000 800 80,800.

123
Green CompanyStatement of Cash Flows (contd.)

• Cash outflows
• Payments to suppliers (52,100)1
• Payments of interest
  (700)
• Other operating payments (15,500)2
• Payments of income tax (3,600)
• Cash outflows
• from operating activities (71,900)
• 1. 48,600 1600 1900 52,100.
• 2. 15,900 - 400 15,500.

124
Green CompanyStatement of Cash Flows (contd.)

• Net cash inflow
• from operating activities 8,900
• A reconciliation of net income and cash flows
  using indirect method must also be presented.

125
Another Example of A Cash Flow Statement
illustration 5-23 (Kieso,etc.,14e)
eso, etc., 14e)
126
Usefulness of The Statement of Cash Flows

• A company with high net income but negative cash
  from operating activities may experience cash
  shortage (i.e., fail to pay liabilities when
  due). Illustration 5-24 (Kieso, etc. 14e)

127
Illustration 5-24 (contd.)

• Hu Inc. could experience cash crunch because it
  has its cash tied up in receivables and
  inventory.
• If Hu encounters problems in collecting
  receivables or in selling its inventory, it may
  not be able to pay its debts on time.
• Investors can use the following ratios to assess
  financial flexibility of companies

128
Financial Flexibility Ratios and Free Cash Flow
(Kieso, etc., illustrations 5-24, 26 and 27)
129
Free Cash Flow Example (Source Kieso, etc., 14e)

• As seen in illustration 5-23, Nestor used its
  free cash flow to redeem bonds.
• Companies with strong financial flexibility can
  take advantage of investment opportunities
  without risking dividend cuts or reducing capital
  expenditures.