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.
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
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). .
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). • . Income Measurement And Profit Analysis
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.
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.
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), periodcosts, (e.g. interest and rent expenses) and estimated expenses (e.g. depreciation expense and bad debt expense). Accrual Accounting and the Financial Statements
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)
What Should Be Included (Reported) in The Income Statement? • Two concepts • Items under debate
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).
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)
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.
Exhibit 4-1 Multiple-Step Income Statement • BANNER CORPORATION • Income Statement • For Year Ended December 31, 20x2 • Sales revenue $150,000 • Less: 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
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
Exhibit 4-1 (contd.) • Income from continuing operations $14,000 • Results 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
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
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
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
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
Exhibit 4-2Single-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 • Dividend 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
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
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
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
Another Example of An Income Statement(Kieso, etc.,illustration 4-17) ssss
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.
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).
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.
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 Inventory Net Purchases = Purchases - Purchases R&A - Purchases Discounts + Freight-In
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
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.
I. Income From Continuing Operations (contd.) e. Income taxes related to continuing operations (an example of an intra-period income tax allocation).
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.
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.
Restructuring Costs (contd.) • Problems associated with this treatment: • Premature restructuring expense/liability recognition. • Violating the matching principle. • Subject to income manipulation.
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.
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 ).
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.
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.).
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.
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)
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”.
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.
When to Report Results of Discontinued Operation? • If a component of a business has either been disposed of orclassified 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.
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).
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).
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).
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.