Chapter 4
Reporting Financial Performance
Prepared by:
Dragan Stojanovic, CA
Rotman School of Management, University of Toronto
Reporting Financial Performance
Income
Statement
•Usefulness
•Limitations
•Quality of
earnings
Format of the
Income
Statement
•Elements
•Single-step
•Multiple-step
•Intermediate
components
•Nature versus
function
•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
•Comprehensive
income
IFRS/Private
GAAP
Comparison
•Comparison
•Analysis
•Looking ahead
2
Reporting Financial Performance
Income
Statement
•Usefulness
•Limitations
•Quality of
earnings
Format of the
Income
Statement
•Elements
•Single-step
•Multiple-step
•Intermediate
components
•Nature versus
function
•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
•Comprehensive
income
IFRS/Private
GAAP
Comparison
•Comparison
•Analysis
•Looking ahead
3
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
4
Overview of the Business Model
5
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
6
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
• Different ways of
measuring income
7
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
• Also, information is clear and concise
8
Reporting Financial Performance
Income
Statement
•Usefulness
•Limitations
•Quality of
earnings
Format of the
Income
Statement
•Elements
•Single-step
•Multiple-step
•Intermediate
components
•Nature versus
function
•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
•Comprehensive
income
IFRS/Private
GAAP
Comparison
•Comparison
•Analysis
•Looking ahead
9
Single-Step Income Statement
•
•
•
•
Presents only two groupings before Income before
Discontinued Operations:
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
10
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 and
Extraordinary Items must be
disclosed separately from
Continuing Operations
11
Multiple-Step Income Statement
• Operating and non-operating activities are
separated
• 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
12
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
13
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
14
Presenting Expenses: Nature
versus Function
• Under IFRS, analysis of expenses must be
presented based on either:
– Nature of expenses (e.g. purchase of materials,
transportation costs, employee benefits,
depreciation, etc)
– Function of expenses (e.g. cost of sales,
administrative costs, etc)
• Choice should result in information that is more
reliable and relevant
• If expenses are presented by function, nature of
expenses must also be disclosed
• No similar requirement under private entity GAAP
15
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 trade-off between
understandability and full disclosure
• Reduces “information overload”
16
Reporting Financial Performance
Income
Statement
•Usefulness
•Limitations
•Quality of
earnings
Format of the
Income
Statement
•Elements
•Single-step
•Multiple-step
•Intermediate
components
•Nature versus
function
•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
•Comprehensive
income
IFRS/Private
GAAP
Comparison
•Comparison
•Analysis
•Looking ahead
17
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
Under IFRS, these items are detailed in the
statement of changes in equity
18
Reporting Irregular ItemsDiscontinued Operations
•
•
-
Discontinued operations includes components
that have been disposed of or are held for sale
Components can include:
- Under private entity GAAP: 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
Private entity GAAP less restrictive
19
Reporting Irregular ItemsDiscontinued Operations
•
•
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
20
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
21
Discontinued OperationsAsset Held for Sale
• Depreciation is not recognized for held for sale
assets
• Remeasured at lower of carrying value and fair
value net of cost to sell
• Once asset is written down, subsequent gains can
be recognized only up to the amount of original
loss
• Presented separately on balance sheet
– Under private entity GAAP, held for sale asset
retains original classification as current or noncurrent
– Under IFRS, held for sale assets generally
classified as current
22
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
23
Extraordinary Items
•
•
•
•
•
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)
Presented separately on the income statement (net of tax);
generally following discontinued operations
IFRS does not allow extraordinary items
Private entity GAAP does not provide guidance on extraordinary
items
24
Unusual Gains and Losses
• Include gains and losses that do not occur
frequently or are not typical for the entity
• If they are material, they are disclosed
separately on the income statement (above
extraordinary items)
• If they are not material, they are shown with
the normal revenues and expenses
25
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
• If change affects future periods, change is
accounted for in those periods as well
• No adjustment is made retroactively (i.e. prior
years are not adjusted)
26
Reporting Financial Performance
Income
Statement
•Usefulness
•Limitations
•Quality of
earnings
Format of the
Income
Statement
•Elements
•Single-step
•Multiple-step
•Intermediate
components
•Nature versus
function
•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
•Comprehensive
income
IFRS/Private
GAAP
Comparison
•Comparison
•Analysis
•Looking ahead
27
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 [not allowed under IFRS]
4. Other comprehensive income
28
Earnings per Share
• Earnings per share (EPS) is 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 EPS based on net income must be
shown on the face of the income statement
• EPS based on discontinued operations may be
disclosed in the notes to the financial statements
29
Earnings per Share
• Calculated as:
Net Income less Preferred Dividends
Weighted Average of Common Shares Outstanding
•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
•
30
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
• Under IFRS, a Statement of Changes in Equity is
presented in lieu of a retained earnings statement.
31
IFRS - Statement of Changes in
Equity
This statement presents the following:
1. Total comprehensive income
2. For each component of equity, the effects of
retrospective application/restatement
3. Reconciliation between the carrying amount
of each component of equity at the beginning
and end of the period.
32
Comprehensive Income
• Includes any item that causes a change in equity except for
– investments by owners
– distributions to owners
– correction of errors and adjustments to retained earnings due to
retrospective application of changes in accounting policy
• Example: unrealized gains/losses on revaluation of property, plant,
and equipment under the revaluation model
• Statement of comprehensive income can be presented either:
– as a single combined statement, or
– as two separate statements
33
Comprehensive Income
Statement
• Example of a combined income and
comprehensive income statement:
•
•
•
•
•
•
Sales
Cost of goods sold
Gross profit
Operating expenses
Net income
Other comprehensive income
– Unrealized holding gain, net of tax
• Comprehensive income
800,000
600,000
200,000
90,000
110,000
30,000
140,000
34
Reporting Financial Performance
Income
Statement
•Usefulness
•Limitations
•Quality of
earnings
Format of the
Income
Statement
•Elements
•Single-step
•Multiple-step
•Intermediate
components
•Nature versus
function
•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
•Comprehensive
income
IFRS/Private
GAAP
Comparison
•Comparison
•Analysis
•Looking ahead
35
Looking Ahead
• IASB and FASB are preparing a converged standard on
“Financial Statement Presentation”
• Working principles state that financial statements
should:
– Provide a cohesive financial picture of an entity
– Provide information to help users assess the liquidity of
an entity
– Separate financing activities from other activities
– Provide information about measurement of assets and
liabilities, and
– Disaggregate information and present subtotals and
totals
• IASB is expected to issue the new standard by 2011
36
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37