Module 2

FA2Module 2. Income statement and balance

sheet presentation

I. Income statement and statement of retained earnings

II. Balance sheet

I. Income statement

1. Theoretical considerations2. Income statement formats3. Components of net income4. Extraordinary items and unusual items5. Intraperiod tax allocation6. Discontinued operations7. Comprehensive income

1. Theoretical considerations

The income statement is the most important financial statement, and net income the most important figure:

• EPS widely predicted and published; earnings surprises rewarded (or punished)

• Income statement information helps to evaluate past performance (feedback value)

• I/S information helps predict future cash flows and risk associated with them

Limitations of the income statement

What is income?Hicks: Income is the maximum amount entity

can distribute to its owners while still maintaining the entity’s net worth

• Earnings figures depend on accounting methods and accounting estimates

• Some firm assets are not recognized as assets; income and net worth are therefore understated

Measuring net worth

In order to measure net income, we must be able to measure net worth. Possibilities:

• Nominal dollars (CICA answer)

• Constant dollars (inflation-adjusted)

• Maintenance of productive capacity

Other assumptions/principles:

• Time-period

• Revenue recognition and matching

Calculating net income

Suppose we have decided how to measure net worth (nominal dollars in Canada). What is the next step?

1. Capital maintenance approach: Income = change in net worth; emphasis on statement of retained earnings

2. Transaction approach: Focus on the transactions that cause changes in net worth; emphasis on income statement

Transaction approach: Elements of the income statement

1. Revenues: Increases in economic resources that result from ordinary activities of the entity, usually from sale of goods or provision of services; also rent, interest, royalties or dividends from investments

2. Expenses: Decreases in economic resources resulting from ordinary revenue-generating activities of the entity

Transaction approach: Elements of the income statement (continued)3. Gains: Increases in equity from peripheral

or incidental transactions and events; and other transactions or events other than revenues or equity contributions

4. Losses: Decreases in equity from peripheral or incidental transactions and events; and other transactions or events other than expenses or distributions of equity

2. Income statement formats

1. Single step income statement

Revenues (and gains, if any)

Expenses (and losses, if any)

Net income

Advantages:

• Simplicity of presentation

• User decides what is important, not management


2. Multiple-step income statementOften includes:• Separation of results related to normal vs.

unusual activities• Expenses grouped by functional category:

cost of goods sold, selling expenses, administrative expenses

• Separate presentation of other, non-operating items: interest, gains, losses


2. Multiple-step income statementAdvantages:• Arguably more informative in that

operating and non-operating items are separated

• Better matching of expenses with related revenues

Note that either format (single- or multiple-) is permitted under GAAP.

Example: A3-9

3. Components of net income

1. Current operating performance concept

Net income should contain only regular, recurring revenues and expenses. Unusual items should be presented on statement of retained earnings.

2. All-inclusive concept

All gains and losses should be included in net income.

What is “relevant” income?

1. Net income

2. Income before extraordinary items

3. Income from continuing operations

4. EBITDA (earnings before interest, tax, depreciation and amortization)

5. Pro forma earnings (includes EBITDA)

6. Core earnings (Standard & Poors)

Bell Canada 2005 earnings

Earnings figure Total ($ billion)

Net income $1.961

Income from continuing operations

$1.92

Operating income $4.048

EBITDA* $7.6

EPS before net gains (losses) on investments, restructuring and other*

$2.05(not billion)

Why calculate a second earnings figure?

“Because the numbers reached by applying GAAP are woefully inadequate when it comes to giving investors a good sense of a company’s prospects. Many institutional investors, most Wall Street analysts, and even many accountants say GAAP is irrelevant . . . The problem is that GAAP includes a lot of noncash charges and one-time expenses.”

- Business Week, November 26, 2001

3. Components of net income

CICA approach: A modified all-inclusive conceptUnusual items are included in income, but some (discontinued operations, extraordinary items) are presented separately on the income statement in order to highlight income from continuing operations and before extraordinary items.This enhances the predictive power of the I/S.

Items that affect shareholders’ equity – where do they go?Income statement: revenues, expenses, most

gains and lossesStatement of retained earnings: effects of

changes in accounting policy, error corrections, effects of some capital transactions

Other comprehensive income: unrealized gains and losses on held-for-sale assets, translation of statements of some foreign subsidiaries, some hedging instruments

4. Extraordinary items

An item is considered extraordinary if it meets all of the three following criteria:

1. Unusual in nature (not typical of normal business activities)

2. Not expected to occur frequently over several years.

3. Does not depend primarily on decisions or determinations by management or owners

Spot the extraordinary items

1. An earthquake destroys one of the oil refineries owned by a large multinational oil company. Earthquakes are rare in this geographical region.


2. A large diversified company sells a block of shares from its portfolio of securities acquired for investment purposes.

3. A company sells a block of common shares of a publicly traded company. The block of shares . . . is the only security investment the company has ever owned.


4. A textile manufacturer with only one plant moves to another location and sustains relocation costs of $725,000.

5. A railroad experiences an unusual flood loss to part of its track system. Flood losses normally occur every three or four years.

Income statement presentation of extraordinary items

Extraordinary items are presented net of tax in a separate section of the income statement, usually just before net income.Revenues XExpenses (including income tax on ordinary items) YIncome before extraordinary item X-YExtraordinary item (net of inc. tax) ZNet income X-Y-Z

5. Intraperiod tax allocation

Income tax expense depends on all other income statement items.

Inc. tax exp = Tax rate (R) X Inc before tax

= (R X Revenue) – (R X Expenses) + . . .

Guiding principle

The income tax effect of major income statement items (continuing operations, discontinued operations, extraordinary items) should be related to the specific item on the income statement.

Example: Viger Ltd.

Viger LtdIncome statement for the year ending Dec. 31,

2000RevenueOperating expensesLoss on operation of discontinued op.Extraordinary gainIncome before taxIncome tax expense (40%)Net income

$400150

4060

270108

$162Prepare an income statement that is consistent with CICA recommendations.

6. Discontinued operations

When a company closes down or sells some component of its organization, it might need to report the component as a discontinued operation.

A discontinued operation is “a component . . . that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the enterprise” (CICA 3475).

Financial statement presentation

Objective: Enhance predictive ability of financial statements

Income statement: Discontinued operation revenues, expenses, gains and losses removed from continuing activities and reported separately

Balance sheet: Discontinued operation assets and liabilities segregated on balance sheet; assets classified as “held-for-sale” (amortization ceases)

When is an operation discontinued?

An operation is held for sale when:

• Management commits itself to sell

• Operation is available for immediate sale

• Buyer is being sought, or plan to shut down has begun

• Sale/shutdown is probable and expected to be completed within one year

• Sale price is reasonable

• Unlikely that plan will change significantly

Income statement presentationPresented as a single item on the income

statement, net of income tax, after income from continuing operations but before extraordinary items, that includes:

• Net profit or loss from operating the discontinued operation during the current year

• Writedown of asset carrying values to fair value less cost to sell

• Any unanticipated gain or loss on disposal (completed shutdowns)

Example: A3-22

7. Comprehensive income

In 2006, Canadian firms had to start reporting comprehensive income, composed of (1) net income and (2) other comprehensive income (OCI).

OCI includes unrealized gains and losses on certain types of transactions – available-for-sale assets, translation of financial statements of a certain type of foreign subsidiaries, and cash flow hedges related to anticipated transactions.

Other comprehensive income on the balance sheet

OCI recognized each year accumulates in the “Cumulative other comprehensive income” account (a shareholders’ equity account) on the balance sheet. When the gains and losses included in OCI are realized, they are transferred from Cumulative OCI to Income statement gain and loss accounts.

Example: A3-13

II. The Balance Sheet

1. Uses and limitations of the balance sheet

2. Balance sheet classifications

3. Balance sheet formats

4. Supplemental disclosure

1. Uses and limitationsUses of balance sheet information• Compute rates of return (income vs. assets

and owners’ equity)• Evaluate firm capital structure (debt vs.

equity financing)• Assess liquidity (ability to meet obligations

coming due) and financial flexibility (ability to alter cash flows to meet unexpected needs or take advantage of unexpected opportunities)

1. Uses and limitations (continued)

Balance sheet limitations• Historical cost basis of valuing many assets

and liabilities• Use of estimates and accounting choices • Balance sheet omits many items that are of

financial value to the firm but cannot be measured reliably (e. g., human resources, internally generated goodwill)

• Numbers are consolidated


Overriding principle: Provide sufficiently detailed information to permit users to assess future cash flows (amounts, timing and uncertainty) and the liquidity, financial flexibility, profitability and risk of the entity. Balance sheet items are sorted according to:

• Type or expected function (assets)• Implications for financial flexibility• Liquidity characteristics


Assets are resources controlled by an enterprise as a result of past transactions or events from which future benefits may be obtained.

• Current assets (cash, accounts receivable, inventories, prepaid expenses)

• Investments (current and non-current)• Capital assets (PP&E plus intangibles)• Other assets (e. g., deferred charges)


Current assets are cash and other assets that are expected to converted into cash, sold or consumed within one year or one operating cycle, whichever is longer.

The operating cycle is the conversion of cash into inventory (through purchase and/or production), then into accounts receivable (through sale) and, finally, back into cash.

Current assets (order of liquidity)

Item Valuation

Cash Market value

Temporary investments

Market value

Accounts receivable Realizable value

Inventory Lower of cost and market

Prepaid expenses Cost

2. Balance sheet classificationsLiabilities are obligations of an enterprise

arising from past transactions or events, the settlement of which may result in the transfer of assets, provision of services, or other yielding of economic benefits in the future.

• Obligations related to operations (accounts payable, future income taxes)

• Unearned revenue• Obligation from financing (loans, bonds)• Contingencies


Current liabilities are obligations that are reasonably expected to be settled through the use of current assets or the creation of other current liabilities (usually, liabilities due within one year)

• Accounts payables• Accrued liabilities (e. g., wages payable)• Unearned revenue• Current portion of long-term liabilities


i. Financing form - account format: emphasis on the entity and how its assets are financed (A = L + OE)

Assets Liabilities

Owners’ equity


i. Financing form – report format: Focus on entity and how it is financed (A = L + OE)

Assets

=

Liabilities

+

Owners’ equity


ii. Net assets form: Focus on owners’ equity (A – L = OE)

Assets

- Liabilities

= Owners’ equity


iii. Financial position form (format linked closely to cash flow statement)

Current assets

Minus: Current liabilities

Equals: Working capital

Long-term assets

Long-term liabilities

Owners’ equity

Example: A4-11

4. Supplemental balance sheet disclosure

1. Contingencies: material events that have an uncertain outcome

2. Valuation and accounting policies: usually footnote #1

3. Contractual situations: covenants or restrictions attached to specific assets or liabilities; commitments

4. Post-balance sheet events

Post-balance sheet events

The post-balance sheet events (or subsequent events) period is the period between the date of the balance sheet and the date of publication of the annual report.Subsequent events occur in time to have an impact on the previous year’s annual report, if necessary.

Types of subsequent events

1. Events that provide additional information about conditions existing at the balance sheet date, information that affects estimates used in preparing the financial statements. An adjustment is required.

This is generally information that would have been in the financial statements were it available.

Types of subsequent events

2. Events that provide information about conditions that did not exist and do not require adjustment to the financial statements. This information should be disclosed as a supplementary note if it affects the financial condition of the entity. Examples include:

• Fire or flood• Decline in value of investments• Issues of share capital or long-term debt

Subsequent events that do not require adjustment or disclosure

These are typically nonaccounting events or events that are generally communicated to users through other means. Examples include:

• Legislation• Product changes• Management changes• Strikes• Unionization

Subsequent events exercise

For each of the following subsequent events, should company (a) adjust financial statements; (b) disclose in note; (c) neither adjust nor disclose?1. Settlement of tax case for amount in excess of amount estimated at year end2. Introduction of new product line3. Loss of assembly plant due to fire4. Sale of significant portion of company assets5. Retirement of company president6. Prolonged employee strike7. Loss of significant customer

Subsequent events exercise

Should company (a) adjust financial statements; (b) disclose in note; (c) neither adjust nor disclose?8. Issuance of significant number of common shares9. Material loss on year-end receivable because of a customer’s bankruptcy10. Hiring of a new president11. Settlement of a prior year’s litigation against the company12. Merger with another company of comparable size

Module 2

Technology

net income income

operating income

assets income

relevant income

net income advantages

extraordinary items

losses statement

net gains losses