Ch 4 - Financial Performance PDF

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Course Textbook: Kieso et al. 2016. Intermediate Accounting, Volume 1, 11th Edition. John Wiley & Sons Canada, Ltd.

Reporting Financial Performance Chapter 4 Uses and Limitations of 

he Income Statement

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Elements of the Income Statement

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Single-Step Income Statement Multiple-Step Income Statement including presentation of expense by function or nature

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Condensed Income Statements Comparative Income Statements

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Earnings per Share (EPS)

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Discontinued Operations

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Comprehensive Income

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Retained Earnings Statement Statement of Changes in Equity

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IFRS/ASPE Comparison

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The Income Statement or Statement of Income/Earnings or Statement of Comprehensive Income The income statement measures the success of a company’s operations over a given period of time (usually a year).

Uses of the Income Statement Evaluate past performance and profitability – users can examine revenue, expenses, gains, and losses, and evaluate management’s performance and compare that performance to other companies (e.g. competitors) Predict future performance – past performance is often a predictor of future performance. Over time, trends can be seen in a company’s performance or industry. (Remember that past success does not guarantee future success!) Assess the risk of achieving future cash flows – segregating the company’s recurring income from its normal operations from the income or loss from non-recurring sources (discontinued operations) helps to identify what sources of cash will continue into the future Limitations of the Income Statement Omissions from the income statement – items that cannot be measured reliably are not included in the income statement; these items could possibly change the income number Income is affected by the methods used – choices made regarding accounting methods (such as depreciation methods) will have a positive or negative impact on the bottom line Accounting relies on the use of estimates – in many cases, we make estimates in order to record entries; estimates of warranty costs, life of assets, collection of accounts receivable, etc. Optimistic or pessimistic estimates will affect net income

Page 2 of 17 Caveat: These notes are predominantly based on the course textbook for Intermediate Accounting 1 by Kieso et al. Discontinue use if textbook changes. Do not use to teach other courses not using this text.

Bias – there are possible motivations for financial reporting bias (e.g. compensation structures and contractual obligations). Earnings management and fraud degrade the quality of financial statements Quality of Earnings The quality of earnings is important because markets are based on trust, and it is imperative that investors have faith in the numbers reported. If that trust is damaged, capital markets will be damaged. Capital markets will value information as high quality if is free from earnings management. Characteristics of high quality earnings: 1. Nature of Content – Unbiased and determined objectively – Represents economic reality – Reflects earnings from on-going core activities – Can be correlated with cash flows from operations – Based on sound business strategy/model 2. Presentation – Does not disguise or mislead (transparent) – Understandable – Also, information is clear and concise Elements of the Income Statement The major elements of the income statement are: Revenues – increases in economic resources. Can be sale of products, fees for services, rent on equipment or property, interest on investments or bank accounts, dividends from other companies, etc. Expenses – decreases in economic resources. Can be the cost of manufacturing or buying product to sell, amortization of fixed assets, interest on loans, rent of equipment or buildings, salaries and wages for staff, taxes, and various other costs of operating the business.

Page 3 of 17 Caveat: These notes are predominantly based on the course textbook for Intermediate Accounting 1 by Kieso et al. Discontinue use if textbook changes. Do not use to teach other courses not using this text.

Gains and losses – usually result from the sale of investments, sale of assets (buildings, equipment, etc.), write-offs due to obsolescence or theft, and so forth. What’s the difference between revenues and gains, and expenses and losses? When is something an expense, and when is it a loss? To answer this, we have to examine the nature of the business, and what its “regular” operations are. For example, Air Canada is in the business of providing transportation through the use of aircraft. Boeing is in the business of manufacturing and selling airplanes. To Air Canada, selling an airplane for a profit would be considered a gain; to Boeing, it would be considered revenue. This can change over time. If Air Canada developed a policy of routinely selling old aircraft at a specified point in their life, and replacing them with new airplanes, this could then be considered a part of their regular operations, and thus a revenue/expense transaction. “Revenue” and “expense” relate to the ongoing, routine business operations of a company: “gain” and “loss” relate to peripheral or incidental transactions.

Single-Step Income Statement The single-step format is most often used by small, simple businesses, such as home-based businesses. There are only two sections, revenues and expenses, and only one subtraction to arrive at net income. It is simple, but generally not very informative, and so is usually used only in small, privately owned companies. Advantages: – Simplicity – Eliminates classification problems for revenues and expenses Disadvantage: Page 4 of 17 Caveat: These notes are predominantly based on the course textbook for Intermediate Accounting 1 by Kieso et al. Discontinue use if textbook changes. Do not use to teach other courses not using this text.

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Oversimplification Less detail (e.g. operating and non-operating activities reported together and cannot be distinguished)

Page 5 of 17 Caveat: These notes are predominantly based on the course textbook for Intermediate Accounting 1 by Kieso et al. Discontinue use if textbook changes. Do not use to teach other courses not using this text.

Multiple-Step Income Statement Many users require more detail, or better information, than the simple, single-step statement can provide. The multiple-step income statement is used almost exclusively by larger, public companies. IFRS requires an entity to present an analysis of expenses based on either nature or function. Nature, depreciation and employee benefits would be presented without breaking down into a function, such as selling or administration. Function requires expenses to be allocated to an entity’s functions, such as cost of sales and administrative costs. IFRS encourages presentation of this information in the income statement (Statement of Earnings), though it may be presented elsewhere as a schedule. UNLESS OTHERWISE STATED, FOLLOW FORMAT ON EXAMPLE BELOW – BY FUNCTION (splitting selling expenses separate from administrative expenses and shown on the multiple-step income statement below) The multiple-step income statement separates operating transactions from non-operating transactions. It separates expenses by function. Financial statements prepared for internal use (i.e. management) tend to be more detailed than those prepared for external use. This contributes to “understandability,” as the more summarized external statements reduce information overload. It also helps management make better decisions, using more detailed information. Regardless of whether a company uses single- or multiple-step income statements, irregular transactions such as discontinued operations must be shown separately from the income from continuing operations.

Page 6 of 17 Caveat: These notes are predominantly based on the course textbook for Intermediate Accounting 1 by Kieso et al. Discontinue use if textbook changes. Do not use to teach other courses not using this text.

Multiple-Step Income Statement (cont)

(Note this company uses a periodic inventory system; therefore, the cost of goods sold is calculated, if perpetual, they would have one account “Cost of Goods Sold”)

Page 7 of 17 Caveat: These notes are predominantly based on the course textbook for Intermediate Accounting 1 by Kieso et al. Discontinue use if textbook changes. Do not use to teach other courses not using this text.

Condensed Income Statements Think about very large corporations like Air Canada, Encana, and so forth. A multiple-step income statement, such as we’ve just looked at, could be several pages long, depending on the specific activities for the year. This would be too cumbersome for most users. Instead, most major corporations will produce “condensed” income statements, showing only the summary totals of each section. The detailed, “multiple-step” sections are attached as Notes to the Financial Statements.

Note that the numbers are the same as in the detailed income statement shown previously; here, only the totals are shown. The detailed calculations will be shown in the various notes.

Page 8 of 17 Caveat: These notes are predominantly based on the course textbook for Intermediate Accounting 1 by Kieso et al. Discontinue use if textbook changes. Do not use to teach other courses not using this text.

Comparative Income Statements Remember, one of the purposes of the income statement is to report on the company’s (and management’s) performance – is the company doing better or worse? To make this comparison easier, most companies will issue comparative statements, showing the current year and the previous year side-by-side.

In order to compare “apples to apples,” each year has to be stated on the same basis. If there are changes to accounting policy between the two years, or errors that must be corrected, we must restate the prior year as required. Earnings Per Share: Under IFRS, EPS must be disclosed on face of income statement for operating income, discontinued items and net income. EPS is equal to: Net Income - Preferred Dividends Weighted Average Common Shares Outstanding

Page 9 of 17 Caveat: These notes are predominantly based on the course textbook for Intermediate Accounting 1 by Kieso et al. Discontinue use if textbook changes. Do not use to teach other courses not using this text.

Discontinued Operations As we discussed before, irregular items (items outside of normal operations) are disclosed separately. One of the most common irregular items is the gain or loss from discontinued operations. Discontinued operations include components of a company that have been disposed of (sold or abandoned), where the operations and cash flows have been eliminated, and the company will no longer have any continuing involvement. Discontinued operations includes components that have been disposed of or are held for sale Components can include:  Under ASPE: an operating segment, reporting unit, subsidiary, asset group, or operations without assets  Under IFRS: separate major line of business or geographical area of operations, or a business qualifying as “held for sale” upon acquisition  IFRS is more restrictive In order to qualify, what’s being disposed of:  

Must be a separate, distinct operating unit Cash flows and financial elements must be clearly distinguishable from the rest of the company

Examples of things that could be discontinued operations:    

A subsidiary company A manufacturing plant A hotel or apartment building A separate line of business

Examples of things that are not discontinued operations:  Sale of inventory  Sale of a machine on the production floor (unless that machine constitutes a distinct operation with its own cash flows) Page 10 of 17 Caveat: These notes are predominantly based on the course textbook for Intermediate Accounting 1 by Kieso et al. Discontinue use if textbook changes. Do not use to teach other courses not using this text.

If the sale hasn’t been completed yet at the end of the fiscal year, the company can consider the asset “held for sale” if:  There is a formal, authorized plan to sell and changes to the plan are unlikely  The asset is available for sale “as is,” is reasonably priced, and we’re actively looking for a buyer  Sale is likely within a year

Presentation of Discontinued Operations Note that discontinued operations are shown after net income from operations (regular, ongoing activities), and that EPS is calculated and shown separately. Also, we show the tax impact in the description of the item.

Page 11 of 17 Caveat: These notes are predominantly based on the course textbook for Intermediate Accounting 1 by Kieso et al. Discontinue use if textbook changes. Do not use to teach other courses not using this text.

Presented separately on balance sheet – Under ASPE, held for sale asset retains original classification as current or non-current – Under IFRS, held for sale assets generally classified as current Depreciation is not recognized for held for sale assets Remeasured at lower of carrying value and fair value net of cost to sell

Comprehensive Income Some types of gains or losses are not included in net income. Rather, they are included in other comprehensive income. Most of these items are “unrealized” gains or losses: in other words, no transaction has taken place, but a gain or loss “on paper” has occurred. Comprehensive Income includes net income plus/minus other comprehensive income. OCI includes: Unrealized gains or losses on certain investments Certain translation gains or losses on foreign currency Unrealized gains or losses on certain hedging transactions We show these types of items separately on the income statement, for two reasons: To reduce fair value fluctuations in net income To inform users of potential gains/losses Items like these are listed after Net Income, under the heading “Other comprehensive income.”

Page 12 of 17 Caveat: These notes are predominantly based on the course textbook for Intermediate Accounting 1 by Kieso et al. Discontinue use if textbook changes. Do not use to teach other courses not using this text.

EPS for comprehensive income is not required. BE4-8, page 186 E4-3, page 188

Retained Earnings There are many events that can cause changes in a company’s Retained Earnings over the course of a year. Net income or net loss, dividends, or changes in accounting policy or corrections of errors (which we’ll cover next course) all have an effect on retained earnings. The retained earnings statement reconciles the beginning balance in retained earnings to the closing balance, thus providing information about how the balance changed over the course of the year. Some companies will have a separate statement of retained earnings, others will combine it with the income statement, and show it at the bottom of the income statement. Companies have the choice of how to display it.

Page 13 of 17 Caveat: These notes are predominantly based on the course textbook for Intermediate Accounting 1 by Kieso et al. Discontinue use if textbook changes. Do not use to teach other courses not using this text.

The statement of retained earnings is not required under IFRS. For Canadian private companies, ASPE requires the statement of retained earnings as one of the four core financial statements.

Statement of Changes in Equity This financial statement is required under IFRS rather than the statement of retained earnings. The statement of shareholders’ equity lists the changes in each account in the shareholders’ equity section of the balance sheet during the year. It describes the changes in the equity (ownership) of the company over the course of the year.

Page 14 of 17 Caveat: These notes are predominantly based on the course textbook for Intermediate Accounting 1 by Kieso et al. Discontinue use if textbook changes. Do not use to teach other courses not using this text.

Remember what happens every year-end: we close all income statement accounts to Retained Earnings. As a result, Retained Earnings shows the overall net income of the company since its beginning (less dividends). Accumulated Other Comprehensive Income serves the same purpose for OCI items: it shows the overall unrealized gains or losses for the company since its beginning. At the end of the year, we close the OCI items from the income statement to Accumulated Other Comprehensive Income. Prior Period Adjustments Because errors and changes in accounting policies are considered to be related to earnings in prior periods, they are not included in current income, but rather as an adjustment in retained earnings (see bottom of page 173). However, changes in accounting estimates (changing estimated useful life of PPE item) are accounted for in the period of change, and if applicable, any future periods. See below for another example of a Statement of Comprehensive Income

Page 15 of 17 Caveat: These notes are predominantly based on the course textbook for Intermediate Accounting 1 by Kieso et al. Discontinue use if textbook changes. Do not use to teach other courses not using this text.

Waterton Corporation Statement of Comprehensive Income For the year ended December 31, 2018 Sales Revenue Sales Less: Sales returns & allowances Net Sales Cost of Goods Sold Gross profit Operating expenses Administrative expenses -456,800 Depreciation expense -68,500 Other revenue & expenses Gain on expropriation of land 65,000 Interest expense -23,800 Loss from disposal of capital assets -18,900 Income from long-term investments 12,000 Income before taxes Income tax expense Income before discontinued items Loss from discontinued operations (net of income tax $29,120) Net income Unrealized Holding Gain - OCI (net of tax $14,140) Total Comprehensive Income Earnings per share Income before Discontinued (308,880 - 36,700)/50,000 Discontinued Operations Net EPS

1,700,000 -52,000 1,648,000 -728,000 920,000

-525,300

34,300 429,000 -120,120 308,880 -74,880 234,000 36,360 270,360

5.44 -1.50 3.95

As we know expenses are a reduction when calculating net income, there is no need to show as a negative amount. E4-10, page 191

Page 16 of 17 Caveat: These notes are predominantly based on the course textbook for Intermediate Accounting 1 by Kieso et al. Discontinue use if textbook changes. Do not use to teach other courses not using this text.

Problems for Practice E4-4 E4-7 E4-12 E4-13 E4-16 E4-18 P4-8 P4-15

Discontinued Operations Income Statement Items Multiple-step Income Statement Multiple-stepIncome Statement Comprehensive Income Earnings per Share Income Statement and Retained Earnings Statement of Changes in Equity

Page 17 of 17 Caveat: These notes are predominantly based on the course textbook for Intermediate Accounting 1 by Kieso et al. Discontinue use if textbook changes. Do not use to teach other courses not using this text....