Agenda

1. Today Monday 1/24 Finish Ch 4, 17, 21 DQ Levitt and Brennan Wed 1/26 Quiz #2 on P&L (no scantron needed) Chapter 5 B/S and SCF Agenda

2. Lists the following for a firm over a period of time: Ongoing Activities Revenues Expenses Incidental or Peripheral Activities: Gains Losses The excess of revenues and gains over expenses and losses is equal to net income for the period. US GAAP vs. IFRS: IFRS requires at least one year of comparative data on income statement (IAS 7) US GAAP has no specific requirement (however, SEC rules require firms to report 3 years of income statement data) Chapter 4The Income Statement

3. Evaluate past performance of a company Feedback value Provide a basis for predicting future performance Predictive value Assist in assessing the risk or uncertainty of future cash flows Predictive value Usefulness of the Income Statement

4. Does not report items that cannot be measured reliably Examples of excluded items? Reported income is a function of the accounting choices made Examples of accounting choices? Managers exercise judgment in measuring income – can lead to earnings management: Managers timing reporting of revenues, expenses, gains and losses to meet their incentives Generally increase current NI which decreases future NI Can also be used to decrease current NI in order to increase future NI Limitations of the Income Statement

5. Examples: Dell Enron Worldcom The Income Statement – Earnings Management

6. Single-Step Income Statement The single-step statement consists of just two groupings: Revenues Expenses Net Income Single- Step No distinction between Operating and Non-operating categories.

7. Multi-Step Income Statement The presentation divides information into major sections. 1. Operating Section 2. Nonoperating Section 3. Income tax

8. Operating Section: Contains information about the operating activity of a business Used as basis for extrapolating into the future May include unusual gains and losses Non-operating Section: Interest expense and revenue Other gains and losses May include unusual gains and losses Income Tax Section: Irregular Items Section: presented “Net of Tax” Discontinued operations Extraordinary items Net of tax Multi-Step Income Statement Presentation

9. Irregular Items Reporting when both Discontinued Operations and Extraordinary Items are present. Discontinued Operations (specify $ or % of tax) Extraordinary Item (specify $ or % of tax)

10. Basic criteria (SFAS 144): Results of operations and cash flows of a component of a company have been (or will be) eliminated from ongoing operations * No significant continuing involvement in that component after disposal transaction * Two important dates in reporting discontinued operations: Measurement date (when management commits itself to a plan of segment’s disposal) Disposal date (the date of sale of the segment). The time between the measurement date and the disposal date is often called the phase-out period Reporting Irregular Items: Discontinued Operations

11. Presentation: Writedown of assets to “fair value less costs to sell” if less than carrying value. No “write-up” recorded if fair value greater than carrying value. Results of operations for both current and prior periods are required to be reported as part of discontinued operations. Both items are reported “net of tax” (i.e. “below the line”). Separate line item for tax expense (benefit) Narrative – “less applicable tax expense (benefit) of $xxx” or xxx% Refer to footnote on the face of the Income Statement Reporting Irregular Items: Discontinued Operations

12. Time Line for Discontinued Operations Measurement Date Year-end Year-end Final Disposal Loss from Operations (B) Prior year: reclassify into loss from op. (A) Part of Loss on Disposition (C) Part of Loss on Disposition: estimate future disposal costs and accrue (D) Combine actual portion (C) + estimated portion (D) = Loss on Disposition on I/S

13. Example: Albertson’s (2003) January 30, 2003 January 31, 2002 Earnings from continuing operations before taxes 1,405 863 Income tax expense 540 367 --------------------------------------- ----------------- ----------- Earnings from continuing operations 865 496 Discontinued operations: Operating (loss) income (50) 10 Loss on disposition (379) - Tax (benefit) expense (143) 5 ------------------------------------- ----------------- ----------- Net (loss) earnings from discontinued operations (286) 5

14. Definition of component (IFRS 5) US GAAP is less restrictive than IFRS definition (IFRS: a reportable business or geographical segment or major component thereof) Continuing Involvement (IFRS 5) IFRS does not address continuing involvement Taxes (IFRS 5) US GAAP requires both pre-tax and post-tax income /loss to be disclosed on face of income statement IFRS requires only post-tax income or loss to be disclosed Discontinued Operations: US GAAP vs. IFRS

15. Extraordinary items must meet BOTH of the following criteria: Event/transaction must be unusual in nature. Event/transaction must occur infrequently. Items are reported “net of tax” (i.e. “below the line”). Items that are NOT Extraordinary Items under GAAP: Losses from write-down or write-off of receivables, inventories, etc. Gains and losses from: Exchange or translation of foreign currency Disposal of a segment of a business Abandonment of property used in business Effects of strike Adjustments or accruals on long term contracts Extraordinary Item classification not allowed under IFRS Reporting Extraordinary Items

16. Extraordinary Item Example Verizon Communications: In January 2007, the Bolivarian Republic of Venezuela declared its intent to nationalize certain companies, including CANTV. On February 12, 2007, we entered into a Memorandum of Understanding (MOU) with the Republic. The MOU provides that the Republic will offer to purchase all of the equity securities of CANTV, including our 28.5% interest…at a price equivalent to $17.85….Based on the terms of the MOU and our current investment balance in CANTV, we recorded an extraordinary loss on our investment of $131 million, net of tax, or $.05 per diluted shares, in the first quarter of 2007.

17. Unusual gains or losses: Restructuring Charges Gains or losses that are generally unusual or infrequent, but not both. Do not qualify as “extraordinary” must be reported above the line in either operating or non-operating section of the income statement. This is an area where managers exercise discretion in presentation. Example: AOL P&L and Note 9 http://www.sec.gov/Archives/edgar/data/1468516/000119312510045310/d10k.htm Reporting Unusual Gains or Losses

18. Categories of Accounting Changes: Change in Accounting Estimate Accounting Errors in Financial Statements Change in Accounting Principle Accounting Changes

19. What possible ways can we handle these changes? 1. 2. 3. Accounting Changes

20. Application of certain accounting concepts requires estimates: Matching concept requires an estimate of the life of long-lived assets Examples: uncollectible accounts, warranty liabilities, depreciation. Estimates updated as new information becomes available. Reporting: Reported prospectively. Change reported in current and future periods No effect on prior periods Reported in the affected accounts, NOT “below the line” Change in Accounting Estimate

21. Example of prospective treatment: Purchase machine on 1/1/05 for $110,000 with an estimated useful life of 10 years and a salvage value of $10,000. Due to technological changes in 2006, it is estimated that the machine will have zero salvage value and will only have a useful life of 4 years beyond 2006. 2006 depreciation and beyond will be: Change in Accounting Estimate

22. Includes: Change from an accounting principle that is not GAAP to GAAP. Mathematical mistakes Changes in estimate that occurs because estimates not prepared in good faith or facts used in error Oversights (ex: failure to accrue or defer expenses and revenues at end of period) Reporting: Reported retrospectively as a “restatement” Correct error in year(s) originally made by a direct entry to the affected line item(s). In following years the effect flows through beginning R/E. If error prior to years presented, just adjust beginning R/E. Errors from previous periods do not flow through current period income. Accounting Errors in F/S

23. Example: ABC company’s auditor found the following errors during the 12/31/10 audit. What is the impact of each error? Assume ABC is public. At the end of 2009, sales salaries of $45,000 were not accrued. In 2010, the company wrote off $87,000 of inventory considered to be obsolete; this loss was charged directly to Retained Earnings and credited to inventory. 2007 depreciation was understated by $100,000. Subsequent years’ depreciation was correctly recorded Accounting Errors in F/S

24. Voluntary adoption of different acceptable accounting principle Common example is LIFO/FIFO/Weighted Average Inventory costing Must demonstrate that newly adopted principle is preferable Treat retrospectively. Need to restate prior years f/s for new method Prior years’ statements presented in the financial statements are recast on a basis consistent with the newly adopted principle. Adjust beginning retained earnings for the earliest year presented to reflect any cumulative effect on periods prior to those presented. Mandated change in accounting principle Generally new standards require a retroactive approach unless it is impracticable If impracticable or choice given to issuer, can report cumulative effect of change as a separate net of tax line item on the Income Statement Example stock options Change in Accounting Principle

25. Example: Mattke Co. (a non-public company) began operations in 2005 and adopted weighted average pricing for inventory. In 2008, Mattke changed to FIFO pricing. Net Income data is: Net Income Net Income Year Wt’d Ave. FIFO 2005 370,000 395,000 2006 390,000 430,000 2007 410,000 450,000 2008 460,000 430,000 How is this reported? Retrospectively, prospectively, currently? Steps to report change. 1) Provide 3 years comparative P&L using restated amounts 2) Provide 2 years comparative B/S using FIFO inventory value and restated Retained Earnings 3) Restate 2006 beginning Retained Earnings to reflect $25,000 higher net income from 2005 What were the journal entries that made the above happen (ignoring taxes)? Change in Accounting Principle

26. Earnings Per Share • Basic EPS • Diluted EPS • Firms required to disclose both basic and Diluted EPS

27. Earnings Per Share Computed as: Net Income less Preferred Dividends Weighted Average of Common Shares Outstanding Disclosed on the I/S for all the major sections: • Income from continuing operations • Discontinued operations loss, net of tax • Income before extraordinary item • Extraordinary item, net of tax • Net income

28. Earnings Per Share Example: • Assume NI of $5K • Pfd Stk Dividends = $1K • 12/31/06 year-end • Outstanding common shares as follows: • 1/1/06: 100 shares • 4/1/06: 200 shares • 7/1/06: 250 shares Weighted Average Calculation:

29. Earnings Per Share Example: At 12/31/06 Shi Corp. had the following stock outstanding: 10% cumulative preferred stock, $100 par, 107,500 shares $10,750,000 Common stock, $5 par, 4,000,000 shares 20,000,000 During 2007, Shi Corp. did not issue any additional common stock. The following also occurred during 2007: Income from continuing operations before taxes $23,650,000 Discontinued operations (loss before taxes) $ 3,225,000 Preferred dividends declared $ 1,075,000 Common dividends declared $ 2,200,000 Effective tax rate 35% Compute EPS as it should appear on the 2007 f/s.

30. Retained Earnings Statement • Increased by net income and decreased by net loss and dividends for the year. • Prior period adjustments to beginning balance • Corrections of errors in prior period financial statements • cumulative impact of changes in accounting policy • Any part of retained earnings appropriated for a specific purpose is shown as restricted earnings. • So dividends can’t be paid out from restricted R/E (can be part of a debt covenant)

31. Comprehensive Income Overview What is comprehensive income? • All changes in equity during a period, except those resulting from investments by or distributions to owners. • Includes “regular” net income • PLUS “other comprehensive income”: • unrealized holding gains or losses on securities (Ch17) • unrealized gains or losses on foreign currency translation • unrealized gains or losses on pension obligations • Other items are presented “net of tax”

32. Unrealized Holding Gains/Losses on Securities • Why do companies invest in debt and equity securities? • < 20% interest assume little or no influence over investee • Report debt intending to hold at “held to maturity” • Record investment at amortized cost • Record interest as income • Report equity & other debt investment using fair value method • Mark investment to “market” on B/S. • Recognize unrealized gain or loss. Where depends upon classification • Trading  Income Statement • Available-for-Sale  Other comprehensive income • Other issues • Can calculate gain or loss at the portfolio level • Potential for earnings management here?

33. Unrealized Gains/Losses Example: on 1/1/09 Big bought shares of Little for $100,000. The shares were < 20% of the total outstanding stock of Little Company. On 12/31/09 the shares had a fair value of $125,000. Little paid dividends of $1000 to Big. How is this accounted for at 1/1/09 and 12/31/09? • If classified as Trading Securities? • If classified as Available for Sale Securities? Do E17-7

34. Presentation of Comprehensive Income Presentation of Comprehensive income • Must be displayed as: • A separate statement of comprehensive income –OR- • Combined income statement and comprehensive income statement –OR- • Part of statement of stockholders’ equity (most companies put it here) • May present net of tax or before tax with a single line reporting taxes on comprehensive income Do E4-14, E4-15