Chapter 4

*Financial ReportingFirms are engaged in 3 main activities:FinancingGetting cashInvestingUsing funds to acquire resourcesOperatingUse of resources to generate profits

*Financial ReportingBalance SheetReports financing and investing activitiesIncome StatementReports operating and performance related activitiesStatement of Cash FlowsReports interrelationship between all three activities

*Uses and Limitations of the Income StatementUses:Evaluate past performance and profitabilityAssist in predicting future performanceAssess potential risk in achieving future cash flowsLimitations:Items are excluded if they cannot be measured reliablyAmounts reported are affected by accounting methods usedUse of estimates in measuring incomeDifferent ways of measuring income

*Quality of EarningsCharacteristics of high quality earnings:Nature of ContentLess biasRepresents economic reality by measuring and recording appropriately all significant events Reflects earnings from ongoing operations so has greater predictive and feedback valueCan be correlated with cash flows from operationsBased on sound business strategy/modelPresentationDoes not disguise or mislead (transparent)Information presented is understandable

*Earnings ManagementOne Definition..a purposeful intervention in the external financial reporting process, with the intent of obtaining private gain

Why Manage Earnings?Boost stock price Meet analysts forecasts Earnings based bonuses Debt covenants

Types of Earnings ManagementConsistent with GAAP (Transaction restructuring)Difficult to distinguish from GAAP (manipulating estimates)Fraud

*Presents only two groupings before Income before Discontinued Operations:Revenues (includes gains)Expenses (includes losses)Income tax expense often reported separate from expenses as the last line item in determining net incomeAdvantages:SimplicityEliminates classification problems for revenues and expensesDisadvantage:Operating and non-operating activities reported togetherSingle-Step Income Statement

*Single-Step Income Statement=RevenuesRevenuesNet SalesOther Revenues(e.g. Dividend, Rental)ExpensesExpensesCost of Goods SoldSelling ExpensesAdministrative ExpensesInterest ExpenseIncome Tax ExpenseNet IncomeGains/Losses fromDiscontinued Operations disclosed separately fromContinuing OperationsEarnings perShare

*Multiple-Step Income StatementOperating and non-operating activities are separated 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 companiesAllows for ratio analysis used to assess performance

*Multiple-Step Income StatementContinuing OperationsNet Sales-Cost of Goods SoldGross Profit-Selling Expenses-Administrative/ General ExpensesIncome from Operations+Other Revenues and Gains-Other Expenses and LossesIncome from Continuing Operations-Income tax Net Income (If no Discontinued Operations)

Earnings per Share(Separate income tax section on Income from Continuing Operations only)

*Multiple-Step Income StatementDiscontinued OperationsIncome/Loss from operationsGain/Loss from dispositionBoth reported net of taxesExtraordinary Items(Only PE GAAP)Material gains/lossesReported net of taxesOther Comprehensive IncomeIncludes other gains/losses not included in net income

BE4-9/10Taylor Corp had net sales revenue of $2,780,000 and investment revenue of $103,000 in 2014. Other 2014 activity:

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Cost of Merchandise Sold$2.19mIncr. in reputation$35,000Salaries & wages175,000Incr. in patent FV17,000Advertising & promotion60,000Interest expense76,000Entertainment37,000Income tax exp.40,000Total Selling expenses272,000Salaries and Wages142,00010,000 shares o/sRent48,000Utilities21,000Administrative Expenses211,000

*Presenting Expenses: Nature versus FunctionUnder IFRS, analysis of expenses must be presented based on either:Nature of expenses (e.g. purchase of materials, transportation costs, employee salaries, depreciation)Function of expenses (e.g. expenditures related to each function: product, selling, and administration)Choice should result in information that is more reliable and relevantIf expenses are presented by function, nature of expenses must also be disclosed No similar requirement under private entity GAAP

*Condensed Income StatementExpenses are reported on the income statement in group totalsDetails of the expense groups are included on supplementary schedulesProvides the advantage of a concise, understandable income statementAn example of trade-off between understandability and full disclosureReduces information overload

*Reporting Irregular Items- Discontinued OperationsDiscontinued operations includes components that have been disposed of or are held for saleThe key is that the component generates its own cash flows and has its own distinct operationsComponents can include:Under private entity GAAP: an operating segment, reporting unit, subsidiary, asset group, or operations without assetsUnder IFRS: separate major line of business or geographical area of operations, or a business qualifying as held for sale upon acquisition

*Reporting Irregular Items- Discontinued OperationsA distinction made between:The components results of operations Gain/Loss from Operations of Disc. OpsDisposal of the components assetsGain/Loss from Disposal of Disc. Ops

*Discontinued Operations-Asset Held for SaleComponent is held for sale if the following criteria are met:Authorized plan to sell existsAsset available for immediate saleActive search for a buyerSale is probable within a yearAsset is reasonably priced and marketedUnlikely that plan to sell will change

*Discontinued Operations-Asset Held for SaleDepreciation is not recognized for held for sale assetsRemeasured at lower of carrying value and fair value net of cost to sellOnce asset is written down, subsequent gains can be recognized only up to the amount of original lossPresented separately on balance sheetUnder private entity GAAP, held for sale asset retains original classification as current or non-currentUnder IFRS, held for sale assets generally classified as current

*Income from continuing operations (net of tax) $xx,xxxDiscontinued Operations: Income (Loss) from operations (net of tax) $xx,xxx Gain (Loss) on disposal (net of tax) xx,xxx xx,xxxNet Income $xx,xxxNet Earnings per share from continuing operations $ xfrom discontinued operations xTotal basic earnings per share $ x

Discontinued Operations Statement Presentation

Discontinued Operations ExampleThe Blue Collar Corp has income from continuing operations of $12.6m in 2014. During 2014 it disposed of it restaurant division at a loss of $111,250 before taxes. The division had an operating loss of $393,750 before taxes. The companys tax rate is 20%.Prepare an Income Statement starting with Income from Continuing Operations.*

*Comprehensive IncomeIncludes any item that causes a change in equity except for investments by ownersdistributions to ownerscorrection of errors and adjustments to retained earnings due to retrospective application of changes in accounting policyExample: unrealized gains/losses on revaluation of property, plant, and equipment under the revaluation modelAdd to Discontinued Operations Example in previous slide:Blue Collar also had an unrealized gain-OCI of $43,000 (net of tax) related to is investments in accordance with IAS39. Prepare a partial statement of comprehensive income for Blue Collar.

*Changes in EstimatesExamples of change in estimates are: change in useful lives and salvage values of capital assets, estimate of bad debtsAccounted for in the current period If change affects future periods, change is accounted for in those periods as wellNo adjustment is made retroactively (i.e. prior years are not adjusted)

*Intraperiod Tax AllocationRefers to the allocation of income taxes within a fiscal periodCertain irregular items on the income statement are reported net of taxSpecifically, income tax expense (or benefit) is calculated and presented separately for the following:Income from continuing operationsDiscontinued operationsOther comprehensive income

*Earnings per ShareEarnings per share (EPS) is considered one of the most significant business indicatorsIndicates dollars earned per common share; it does not report the dollars paid (or to be paid) per common shareEPS based on earnings before discontinued operations and EPS based on net income must be shown on the face of the income statementEPS based on discontinued operations may be disclosed in the notes to the financial statements

*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 presentedEarnings per ShareWeighted Average of Common Shares OutstandingNet Income less Preferred Dividends Calculated as:

Statement of Retained EarningsRetained Earnings affected by:Net Income/LossCash and Share DividendsRetroactive changes of accounting policy i.e. Inventory valuation method.Prior period errors*

Statement of Retained EarningsBalance, January 1, as reportedCorrectionsBalance, January 1, as adjustedAdd: Net Income$ XXX,XXXLess: Cash DividendsLess: Stock DividendsBalance, December 31*

IFRS - Statement of Changes in EquityThis statement presents the changes in each shareholders equity accountTotal comprehensive incomeReconciliation between the carrying amount of each component of equity at the beginning and end of the period.

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Statement of Changes in Equity*

Total =Common SharesRetained EarningsAccumulated OCIBeginning BalanceComprehensive Income: Net Income OCIDividendsEnding Balance

BE4-13Your Pal Postcard Co. Ltd reports the following for 2014: Net Income $50,000, unrealized gain of fair value-OCI investments $60,000. The company has January 2, 2014 balances as follows: common shares $600,000, accumulated other comprehensive income $250,000 and retained earnings $900,000. The company did not issue any shares during 2014. On December 15, 2014 the board of directors declared a $300,000 dividend payable on January 31, 2014. Prepare a statement of changes in equity. Ignore taxes.*

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