Chapter 4
Reporting Financial Performance
Prepared by:
Patricia Zima, CA
Mohawk College of Applied Arts and Technology
Reporting Financial Performance
Income
Statement
•Usefulness
•Limitations
•Quality of
earnings
Format of the
Income
Statement
•Elements
•Single-step
•Multiple-step
•Intermediate
components
•Condensed
income
statement
Reporting
Irregular Items
•Discontinued
operations
•Extraordinary
items
•Unusual gains
and losses
•Changes in
estimates
Special Reporting
Issues
•Intraperiod tax
allocation
•Earnings per share
•Retained earnings
statement
•Comprehensive
income
•Perspectives
•International
Appendix 4A –
Cash Basis vs.
Accrual Basis
Earnings
•Differences
between cash
and accrual basis
•Conversion from
cash to accrual
basis
•Theoretical
weaknesses of
cash basis
2
Financial Reporting
•
•
Business Model identifies three activities:
1. Financing
• Obtaining cash funding
2. Investing
• Use of funding to obtain resources
3. Operating
• Use of resources to generate profits
Financial statements should capture these
fundamental business activities
3
Financial Reporting
1. Balance Sheet
• Reports financing and investing activities
2. Income Statement
• Reports operating and performance
related activities
3. Statement of Cash Flows
• Reports interrelationship between all
three activities
4
Uses and Limitations of the
Income Statement
Uses:
• Evaluate past
performance and
profitability
• Assist in predicting
future performance
• Assess potential risk
or uncertainty in
achieving future cash
flows
Limitations:
• Items are excluded if
they cannot be
measured reliably
• Amounts reported are
affected by
accounting methods
used
• Use of estimates in
measuring income
5
Quality of Earnings
•
The reliability of the information presented is
dependent on the quality of earnings
• Characteristics of high quality earnings:
1. Nature of Content
• Unbiased and determined objectively
• Represents economic reality
• Reflects earnings from ongoing operations
• Can be correlated with cash flows from operations
• Based on sound business strategy/model
• Presentation
• Does not disguise or mislead (transparent)
• Information presented is understandable
6
• Also, information is clear and concise
Single-Step Income Statement
•
•
•
•
Presents only two groupings before Income before
Discontinued Operations and Extraordinary Items:
1. Revenues (includes gains)
2. Expenses (includes losses)
Income tax expense often reported separate from
expenses as the last line item in determining net income
Advantages:
– Simplicity
– Eliminates classification problems for revenues and
expenses
Disadvantage:
– Operating and non-operating activities reported
together
7
Single-Step Income Statement
Revenues
–
Expenses
=
Net Income
Earnings per
Share
Revenues
Net Sales
Other Revenues
(e.g. Dividend, Rental)
Expenses
Cost of Goods Sold
Selling Expenses
Administrative Expenses
Interest Expense
Income Tax Expense
Any Gains/Losses from
Discontinued Operations or
Extraordinary Items must be
disclosed separately from
Continuing Operations
8
Multiple-Step Income Statement
• Operating and non-operating activities are
separated
• Expenses are classified by function (e.g. Selling
and Administrative Expenses, Cost of Goods
Sold)
• 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 companies
• Allows for ratio analysis used to assess
performance
9
Multiple-Step Income Statement
Continuing Operations
•Operating section
•Nonoperating section
•Income tax
•Income/Loss from operations
Discontinued Operations •Gain/Loss from disposition
•Both reported net of taxes
Extraordinary Items
•Material gains/losses
•Reported net of taxes
Other Comprehensive Income
•Includes other
gains/losses not
included in net income
10
Continuing Operations–Detail
Operating Section
•Net Sales
•Cost of Goods Sold
•Selling Expenses
•Administrative or General Expenses
Nonoperating Section
Income Tax
•Other Revenues and Gains
•Other Expenses and Losses
•Separate income tax section on
Income from Continuing
Operations only
11
Condensed Income Statement
• Expenses are reported on the income
statement in group totals
• Details of the expense groups are included
on supplementary schedules
• Provides the advantage of a concise,
understandable income statement
• An example of tradeoff between
understandability and full disclosure
• Reduces “information overload”
12
Reporting Irregular Items
•
•
•
Income measurement currently follows a
modified all-inclusive approach
Most irregular items included in income
except for the following:
1. Prior years’ income errors
2. Retroactive changes in accounting
policies
The above exceptions are recorded as
adjustments (reported net of tax) on the
Statement of Retained Earnings
13
Reporting Irregular ItemsDiscontinued Operations
•
•
•
•
Discontinued operations includes components
that have been disposed of or are held for sale
Components include:
- An operating segment
- A reporting unit
- A subsidiary
- An asset group
A distinction made between:
- The component’s results of operations
- Disposal of the component’s assets
The key is that the component generates its own
cash flows and has its own distinct operations
14
Discontinued OperationsAsset Held for Sale
• Component is held for sale if the following criteria
are met:
– Authorized plan to sell exists
– Asset available for immediate sale
– Active search for a buyer
– Sale is probable within a year
– Asset is reasonably priced and marketed
– Unlikely that plan to sell will change
• These assets carried at lower of carrying value
and fair value (net of cost to sell)
15
Discontinued Operations– Statement
Presentation
Income from continuing operations (net of tax)
$xx,xxx
Discontinued Operations:
Income (Loss) from operations (net of tax) $xx,xxx
Gain (Loss) on disposal (net of tax)
xx,xxx xx,xxx
Net Income
$xx,xxx
Earnings per share from continuing operations
$
Earnings per share from discontinued operations
Earnings per share on net income
x
x
$
x
16
Extraordinary Items
•
•
•
Presented separately on the income statement
(net of tax); generally following discontinued
operations
Characteristics:
– Material amounts
– Non-recurring items
– Differ significantly from the typical business
activities
Three qualifying criteria (all three must be met):
1. Infrequent
2. Atypical of normal business activities
3. Not primarily dependent on decisions made by
management (or owners)
17
Extraordinary Items
•
CICA Handbook, Section 3480 specifies that
the following gains and losses are not
extraordinary items:
1) Losses or loss provisions from bad debts
and inventories
2) Foreign exchange gains and losses
3) Contract price adjustments
4) Gains and losses from investment write
downs
5) Income tax adjustments
6) Income tax rate or law changes
18
Unusual Gains and Losses
• Include gains and losses that do not qualify
as an extraordinary item but are material in
amount
• If they are material, they are disclosed
separately on the income statement (before
extraordinary items)
• If they are not material, they are shown with
the normal revenues and expenses
19
Changes in Estimates
• Examples of change in estimates are: change
in useful lives and salvage values of capital
assets, estimate of bad debts
• Accounted for in the current period
• No adjustment is made retroactively (i.e. prior
years are not adjusted)
• If change affects future periods, change is
accounted for in those periods as well
20
Intraperiod Tax Allocation
•
Refers to the allocation of income taxes
within a fiscal period
• Certain irregular items on the income
statement are reported net of tax
• Specifically, income tax expense (or benefit)
is calculated and presented separately for
the following:
1. Income from continuing operations
2. Discontinued operations
3. Extraordinary items
21
Earnings per Share
• Earnings per share (EPS) considered one of the
most significant business indicators
• Indicates dollars earned per common share; it does
not report the dollars paid (or to be paid) per
common share
• EPS based on earnings before discontinued
operations and extraordinary items and EPS based
on net income must be shown on the face of the
income statement
• EPS based on discontinued operations and EPS
based on extraordinary items may be disclosed in
the notes to the financial statements-see HB
3500.60 and 3500.61
22
Earnings per Share
• Calculated as:
Net Income less Preferred Dividends*
Weighted Average of Common Shares Outstanding
*Preferred dividends are those dividends that have
been declared (for non-cumulative) or one year’s
fixed dividend amount (for cumulative)
•
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 presented
•
23
Retained Earnings Statement
• Retained earnings increases by net income and
decreases by net loss and declared dividends (both
cash and stock dividends) for the year
• Correction of errors in prior periods and effects to
prior periods from accounting policy changes are
treated as prior period adjustments
• They adjust (net of tax) beginning retained earnings;
also prior years’ financial statements are often
restated
• Must disclose any part of retained earnings
appropriated (restricted) for a specific purpose
(e.g. contractual obligation, corporate policy)
24
Comprehensive Income
• Includes any item that causes a change in equity
except for investments by owners and distributions
to owners
• Under all-inclusive income approach, the following
items are included as other comprehensive income:
– Unrealized gains/losses on available-for-sale
securities
– Certain translation gains/losses on foreign
currency
– Unrealized gains/losses on certain hedging
transactions
25
Comprehensive Income
•
•
Separate disclosure of these equity items would:
1. Highlight the impact on net income of fair
value fluctuations
2. Inform users of potential gains/losses
AcSB disclosure for other comprehensive income
items requires:
– Expanded income statement or the
statement of shareholders’ equity, or adding
another statement
– Comprehensive EPS not required to be
disclosed
26
International Issues
•
The IASB involved in “Financial Statement
Presentation” project which consists of three
phases:
1. Phase A - What constitutes a complete set
of financial statements
2. Phase B - Presentation of information on the
face of the statements
3. Phase C - Interim financial reporting
27
COPYRIGHT
Copyright © 2007 John Wiley & Sons Canada, Ltd.
All rights reserved. Reproduction or translation of
this work beyond that permitted by Access Copyright
(The Canadian Copyright Licensing Agency) is
unlawful. Requests for further information should be
addressed to the Permissions Department, John
Wiley & Sons Canada, Ltd. The purchaser may make
back-up copies for his or her own use only and not
for distribution or resale. The author and the
publisher assume no responsibility for errors,
omissions, or damages caused by the use of these
programs or from the use of the information
contained herein.
28