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 COPYRIGHT Copyright © 2010 John Wiley & Sons Canada, Ltd. 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