the income statement and statement of cash flows
DESCRIPTION
The Income Statement and Statement of Cash Flows. 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. - PowerPoint PPT PresentationTRANSCRIPT
Intermediate Financial Accounting I
The Income Statement and Statement of Cash Flows
2
Objectives of the Chapter1. 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).
.
Income Measurement And Profit Analysis 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.
Accrual Accounting and the Financial Statements 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).
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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)
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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).
Numbers of Irregular Items Reported in Recent Years by 500 Large Companies (Source: Kieso, etc., 14th e, illustration 4-5)
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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
BANNER CORPORATIONIncome Statement
For Year Ended December 31, 20x2Sales revenue
$150,000Less: Sales returns and allow. $4,000
Sales discounts taken $2,300 (6,300)
Net sales $143,700Cost of goods sold (Note A)
(86,000)Gross profit
$57,700Operating expenses
Selling expenses (Note B) $10,200General and administrative exp. (Note C) 16,000Depreciation expense 7,800
Exhibit 4-1 Multiple-Step Income Statement
15
16
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
Exhibit 4-1 (contd.)
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17
Income from continuing operations$14,000
Results from discontinued operationsIncome from operations of discontinued component A (net of $1,950 I/T) $4,550Loss 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
Exhibit 4-1 (contd.)
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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
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19
Note A: Cost of Goods Sold
Inventory, 1/1/x2 $40,000Purchases $120,000
Less: Purchase discounts (5,000)Freight-In 10,000Net purchases 125,000Total inv. available for sale 165,000
Less: inventory, 12/31/x2 (79,000)Cost of goods sold $86,000
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Note B: Selling Expenses
Sales salaries and commissions $3,000Sales office salaries 2,000Travel and entertainment 1,000Advertising expenses 1,000Freight-out 800Shipping supplies and expenses 1,700Postage and stationery 400Telephone & telegraph expenses $10,200
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Note C: General and Administrative Expenses
Offices’ salaries $10,000Legal and professional services 2,000Utility expense 2,000Insurance expense 1,000Stationery, supplies and postage 500Miscellaneous office expense 500
$16,000
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BANNER CORPORATIONIncome Statement
For Year Ended December 31, 20x2Revenues
Sales rev. (net of $2,300 discounts and $4,000 returns and allow.) $143,700Interest revenue 1,800Dividend revenue 600Total revenues
$146,100Expenses
Cost of goods sold (Note A) $86,000Selling expenses (Note B) 10,200General and administrative expenses. (Note C) 16,000
Exhibit 4-2 Single-Step Income Statement
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General and administrative expenses. (Note C) 16,000Depreciation expense 7,800Loss on sale of equipment 4,000Interest expense 2,100Income tax expense 6,000
Total expenses(132,100)
Income from continuing operations $14,000
Results form discontinued operationsIncome from operations of discontinued component A (net of $1,950 I/T) $4,550Loss on disposal of component A (net of $3,150 I/T credit) (7,350)
(2,800)
Exhibit 4-2 (contd.)
23
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Loss on disposal of component A (net of $3,150 I/T credit) (7,350)
(2,800)Income bef. extraordinary items
$11,200Extraordinary loss from explosion
(net of $750 I/T credit)(1,750)
Net income$9,450
Exhibit 4-2 (contd.)
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
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Another Example of An Income Statement(Kieso, etc.,illustration 4-17) ssss
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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.
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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).
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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 R&A - sales Discounts
b. C.G.S.: (see Note A)Perpetual Inventory system.Periodic Inventory system.CGS = Beginning Inventory + Net Purchases
- Ending InventoryNet Purchases = Purchases - Purchases R&A
- Purchases Discounts + Freight-In
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I. Income From Continuing Operations (contd.)
c. Operating expenses (see Ciena Corp. annual report of 2008): Cost incurred to generate operations includingResearch and Development Selling Expense (see Note B) Administrative Expense (see Note C) Depreciation and amortization Exp.Restructuring costsGoodwill and long-lived asset impairments
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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.
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I. Income From Continuing Operations (contd.)
e. Income taxes related to continuing operations (an example of an intra-period income tax allocation).
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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.
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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.
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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 ).
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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 company’s 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.).
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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.
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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.
Pro Forma Earnings versus Earnings from Operations (Kieso, etc. 14th e, p158)
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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”.
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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.
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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.
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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).
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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).
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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.
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Reporting Elements (contd.)
These two elements can be combined or reported separated.
If combined, the disposal gain or loss must be disclosed.
The Income Statement and Statement of Cash Flows 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/x3Phase-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.
Measurement date Disposal date
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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.
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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.
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Case II: Expected Disposal Date is after the FYE Date
Measurement Date FYE Expected Disposal Date1/1/x3 8/1/x3 12/31/x3 5/1/x4
Phase-out period
Realized operating income (1/1/x3 -12/31/x3) = $25,000Impairment 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.
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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.
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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.
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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).
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Examples
Direct result of a major casualty (i.e., flood, earthquake….).
Expropriation by a foreign government.
Prohibition under a newly enacted law.
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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.
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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.
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IV. Earnings Per Share
Basic Diluted EPS* EPS
Continuing operations xx xxDiscontinued operations xx xxExtraordinary Items xx xxTotal xx xx
* EPS = Net Income - Preferred Dividends Weighted Average of Common Share Outstanding
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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.
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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.
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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.
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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. 2,000Allow. for bad debt2,000
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.
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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
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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.
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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 => ($15,000-$9,000)=$6,000 $6,000x2/3=$4,000; and 20x6=> 6,000x1/3 = $2,000.
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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.
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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).
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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.
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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.
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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.
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Changes in Accounting Principle (contd.) (skip)
Retrospective application of the new standard is Impracticable when:
1) The effects of the retro. application are not determinable.
2) The application requires assumptions regarding manager’s intent in a prior period.
3) 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.
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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.
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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.
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Other Items Related to Income Statement Reporting1. 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.
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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.
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Comprehensive Income (SFAS No. 130) The change in equity excluding owner
related transactions such as investments from owners and dividends distribution.
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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.
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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)
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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.
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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.
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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
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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
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B. Combined Income Statement Format
Avon Corp.Combined Statement of Comprehensive Income For the Year Ended 12/31/x1 Sales Revenue $1,000,000CGS 500,000Gross Profit 500,000Operating Expenses $100,000Net Income $400,000Unrealized Loss, net of tax 40,000Comprehensive Income $360,000
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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:
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C. Statement of Stockholders’ Equity Format (contd.)
Accum. Other
Comprehensive Retained Compre. Comm. Income Earnings Income Stock Total
Beg. Balance $0 600,000 150,000 500,0001,250,000Compre. 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 1,000,000 110,000 500,0001,610,000
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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
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Statement of Retained Earnings
Reporting Items: N/I Dividends (cash + stock) Prior-period adjustment (Net of I/T)
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Justin Rose, Inc.Retained Earnings Statement
For the Year Ended December 31, 2012
Balance, January 1, as reported $1,050,000Correction for understatement of net income in prior period-inventory error (net of tax) 50,000Balance, January 1, as adjusted 1,100,000Add: Net income 360,000
1,460,000Less: Cash dividends $100,000
Stock dividends 200,000 300,000Balance, December 31 $1,160,000
Exhibit 4-3 (Kieso, etc., 14th edition, illustration 4-18)
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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.
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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.
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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.
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)
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Why Can Earnings Be Managed?
Determining when revenue has been earned (critical event) and is realized (measurability)—the two revenue recognition conditions—often requires management judgment.
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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 company’s underlying performance.
Some managers have achieved earnings management by financial frauds (that’s illegal).
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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 R&D” that SFAS No. 2 requires to be expensed at the date of acquisition.
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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.
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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).
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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..
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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).
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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 WorldCom’s improper capitalization of its line costs of $3.8 billion in 2000-01.
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Earnings Management of Allocation Costs
Allocation Costs (i.e., depreciation expense):
May be subject to earnings management due to GAAP’s flexibility in allocation methods.
The estimation of expenses is subject to managers’ discretion.
Revenue Recognition Abuses:SAB 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
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Revenue recognition abuses:SAB 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.
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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.).
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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.
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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
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The Limitations of the Income Statement
1. 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.
2. For investments reported at market value, the unrealized gains/losses of some are reported only in the balance sheet statement.
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The Limitations of the Income Statement (contd.)3. Income is based on many estimates
which are discretionary and require judgments.
4. Income is affected by the choice of accounting methods.
5. Income can be manipulated by managers.
6. Off balance sheet liability (thus, off I/S expense).
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Statement of Cash Flows
Statement of Cash Flows: Providing uses and sources of cash
and operating, financing and investing information of a business entity.
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Statement of Cash Flows (SFAS No. 95)
Three Sections:
1. Cash flows from operating activitiesN/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).
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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).
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GREEN CompanyStatement of Cash Flows
For the Year Ended December 31, 2012Net cash flows from operating activities:Net Income $8,400Adj. To reconcile net income to net cash provided by operating activities:Add: Depreciation Expense 3,400
Decrease in A/P 800Increase 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
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Cash flows from investing activities:Payments for purchase of equip. (15,200)Proceeds from sale of equipment 2,100
Net cash used by investing activities (13,100)
Cash flows from financing activities:Proceeds from issuance of bonds 8,000Payments of dividends (1,800)
Net cash provided by financing activities 6,200
Net increase in cash $2,000Cash, Jan 1, 20x2 $3,500Cash, Dec 31, 20x2 $5,500
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GREEN Company Statement of Cash Flows (contd.)
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Schedule 1: Investing & financing activities not affecting cash flows:
Investing activities:
Acquisition of land by Issuance of common stock ($4,000)
Financing Activities:
Issuance of common stock for land $4,000
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GREEN Company Statement of Cash Flows (contd.)
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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.
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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.
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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.
Another Example of A Cash Flow Statement: illustration 5-23 (Kieso,etc.,14e) eso, etc., 14e)
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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)
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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:
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Financial Flexibility Ratios and Free Cash Flow (Kieso, etc., illustrations 5-24, 26 and 27)
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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.
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