FA2
Module 2. Income statement and statement
of financial position presentation
I.
II.
Statements of income and comprehensive
income
Statements of financial position and changes in
equity
Remember the attendance sheet!
I. Statements of income and comprehensive
income
1.
2.
3.
4.
5.
6.
Theoretical considerations
Income statement presentation
Asset disposals
Discontinued operations
Intraperiod tax allocation
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
confirm past predictions (feedback value)
• I/S information helps predict future cash
flows and risk associated with them
Nature of income
Economic income: Income is change in
wealth – events approach, i. e., watch for
events that change wealth (e. g., changes in
fair value of asset)
Accounting income: Traditionally based on
transactions approach, i. e., income is
recognized only as result of transactions (e. g.,
item sold for amount different than its
historical cost)
More recently, accounting income moving
closer to economic income
Nature of income (cont’d)
Comprehensive income
• all changes to owners’ equity not the result
of transactions with owners in their capacity
as owners (e. g., dividends, share capital)
• Two categories of comprehensive income
– Periodic profit/loss (net income)
– Other comprehensive income (OCI) – changes
in balance sheet values that are not yet
recognized in net income (profit or loss)
Nature of income (cont’d)
Items not included in net income
• all changes to owners’ equity that result
from transactions with owners in their
capacity as owners (e. g., dividends, share
capital)
• OCI (other comprehensive income)
• cumulative adjustments to retained earnings
that result from changes in accounting
policies and corrections of errors
Nature of income (cont’d)
Presentation of comprehensive income
1.Single statement that combines income
statement and OCI
Revenue
$
Expense
$
Net income
$
OCI
$
Comprehensive income
$
Nature of income (cont’d)
Presentation of comprehensive income
2.Income statement plus statement of
comprehensive income
Revenue
$
Expense
$
Net income
$
Net income
OCI
Comprehensive income
$
$
$
2. Income statement presentation
Required components (IFRS)
• Revenues
• Finance costs (interest expense)
• Share of earnings from associated cos.
• Profit or loss on discontinued operations,
net of tax
• Net income
• Earnings per share
Lots of additional note disclosure
2. Income statement presentation
Alternative formats
1. Classification by nature of expense
Classification on the basis of inputs – what
the money was spent on (e. g., salaries,
amortization)
2. Classification by function
Output-based classification – what money was
used for (cost of goods sold, operating
expenses, selling and administrative
expenses)
Example: Nature vs. Function
Chen Inc.
Expense
Depreciation
Salaries
Other
Cost of goods sold
Selling
Administrative
Total
Total
$500
$120
$100
$40
260
60
110
30
200
$180
$210
$70
$960
Revenue for the year was $1,400. Prepare an income statement for Chen for the year,
classifying expenses by (a) nature and (b) function.
(a) Chen Inc.
Income statement: Expenses classified by
nature
Chen Inc.,
Income Statement for the year
ended December 31
Revenue
$1,400
Cost of Goods Sold
500
Depreciation expense
180
Salaries expense
210
Other expenses
70
Net income
$440
(b) Chen Inc.
Income statement: Expenses classified by
function
Chen Inc.,
Income Statement for the year
ended December 31
Revenue
$1,400
Cost of Goods Sold
500
Selling expense
260
Administrative expense
200
Net income
$440
2. Income statement formats
1. Single-step income statement
Revenue
$
Expenses
$
Net income
$
Simple presentation, allows (forces) users to
decide what importance to attach to each item.
Disadvantages: GAAP requires separate
presentation of items like discontinued
operations
2. Income statement formats
2. Multiple-step income statement
Often 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, nonoperating items: interest, gains, losses
2. Income statement formats
2. Multiple-step income statement
Advantages:
• Arguably more informative in that
operating and non-operating items are
separated
• Better matching of expenses with related
revenues
Example: A3-6
3. Asset disposals and restructuring
Asset disposal means disposal of a (usually
non-current) asset by abandonment or sale.
Abandoned asset: No longer used in company
operations but there are no plans to sell.
Amortization stops, asset is written down to
lower of net realizable value (fair value less
costs to sell) and carrying value.
Asset remains classified as non-current.
Planned disposal of assets by sale
Individual assets
Current assets: Written down to lower of
NRV and carrying value and left as current
asset
Non-current assets: Once removed from use,
amortization ceases. Asset written down to
lower of NRV and carrying value. If right
conditions are met, asset is classified as heldfor-sale and reclassified as current asset.
Conditions for held-for-sale classification
1. Asset available for immediate sale in
present condition
2. Asset sale is highly probable
–
–
–
–
Price asked for asset is reasonable
Active program to find buyer has started
Management committed to selling asset
Unlikely that offer to sell will be withdrawn or
terms significantly changed
– Sale expected to take place within one year of
reclassification as held-for-sale
Recording non-current asset as held-for-sale
1. Asset is remeasured at lower of NRV and
current carrying value; any loss determined
as result of remeasurement is recognized
2. Asset is reclassified as held-for-sale if all
of the criteria are met
Amortization ceases. Accumulated
depreciation is eliminated.
Recording non-current asset as held-for-sale
Example: A3-14 (c): Panych ceased to use a
company-owned cargo plane on September
30. The plane cost $7,000,000 and now has a
carrying value of $2,400,000. The company
plans to find a buyer as quickly as possible,
and has engaged a dealer to look for a buyer.
The agent expects to find a buyer within the
following six to eight months. The asking
price is $2,000,000. The dealer will take a 3%
commission on the sale.
Prepare journal entries and show how the
assets will be reported on balance sheet.
4. Discontinued operations
A discontinued operation is an operating
segment that contains a “cash generating unit”
(group of assets that generates cash flows that
are independent of cash flows from other
assets or groups of assets) and has either been
sold or is held-for-sale (same criteria as for
assets).
The segment is separable from the rest of the
organization.
Under IFRS, discontinued operations are only
major organizational segments.
Components of net income
1. Current operating performance concept
Net income should contain only regular,
recurring revenues and expenses. Unusual
items should be presented on statement of
retained earnings.
2. All-inclusive concept
All gains and losses should be included in net
income.
What is “relevant” income?
1. Net income
2. Income from continuing operations
3. EBITDA (earnings before interest, tax,
depreciation and amortization)
4. Pro forma earnings (includes EBITDA)
5. Core earnings (Standard & Poors)
Bell Canada 2010 earnings release
Earnings figure
Net earnings for common
Net earnings before
investments, restructuring
and other
Operating income
EBITDA*
Free cash flow*
Total ($ billion)
$2.165
$2.159
$3.292
$7.188
$1.374
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
Components of net income
IFRS approach: A modified all-inclusive
concept
Unusual items are included in income, but
discontinued operations are presented
separately on the income statement in order to
highlight income from continuing operations.
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 losses
Statement of changes in equity: 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
Discontinued operations and the
financial statements
Income statement
• Net profit or loss from operating
discontinued operation until date of disposal
or year-end if disposal not complete by year
end, net of income tax
• Writedowns of asset carrying values to net
realizable value, plus all realized gains and
losses on disposal not previously
recognized, net of income tax
Discontinued operations and the
financial statements
Statement of financial position
• Assets are reclassified as held-for-sale and
reported as single current asset
• Liabilities associated with segment are
reclassified as single current liability
Discontinued operations example
On September 1, Hatchet Ltd. closed and
decided to sell off its unprofitable Service
Division. The division has non-current capital
assets with a carrying value of $300 (cost =
$500, accumulated depreciation = $200) and a
fair value of $250. Selling costs are expected
to be $10. Its current assets have a carrying
value and fair value of $100. Hatchet’s tax
rate is 40%.
Prepare the journal entry required on Sept. 1.
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) should be related to
the specific item on the income statement.
Example: Viger Ltd.
Viger Ltd
Income statement for the year ending Dec. 31,
2010
Revenue
$400
Operating expenses
150
Loss on operation of discontinued op.
40
Gain on sale of investment
60
Income before tax
270
Income tax expense (40%)
108
Net income
$162
Prepare an income statement that is consistent with
IFRS.
6. 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-forsale 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: A3-9
II. Statements of Financial Position (SFP)
and Changes in Equity
1.
2.
3.
4.
5.
Uses and limitations of the SFP
SFP classifications
SFP formats
Statement of Changes in Equity
Disclosure notes
Remember the attendance sheet!
1. Uses and limitations
Uses of SFP 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)
SFP limitations
• Historical cost basis of valuing many assets
and liabilities
• Use of estimates and accounting choices
• SFP 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
2. SFP classifications
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
2. SFP classifications
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)
2. SFP classifications
While not required under IFRS, most
Canadian companies distinguish between
current and non-current assets and liabilities.
Current assets are cash and other assets that
are expected to be 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
Accounts receivable
Market value
Inventory
Lower of cost and net
realizable value
Cost
Prepaid expenses
Realizable value
2. SFP classifications
Liabilities 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
2. SFP classifications
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
Example: A4-11
4. Statement of changes in equity (SCE)
Discloses the components of equity and the
changes in each of those components during
the reporting period. Typical components are:
• Share capital
• Additional paid-in capital/contributed
surplus
• Equity components of hybrid instruments
• Retained earnings
• Cumulative other comprehensive income
• Non-controlling interest
SCE Example
The balances in Richmond Inc.’s shareholders equity
accounts on December 31, 20x8 were as follows:
Common shares
Retained earnings
Total
$500
$250
$750
During 20x9, Richmond changed accounting methods
to provide more relevant information to shareholders.
The cumulative effect was to increase retained earnings
by $60 as of Dec. 31, 20x8. Richmond issued common
shares during 20x9 for $120. 20x9 net income was $35
and cash dividends of $40 were declared.
5. Disclosure notes
1.
2.
3.
4.
5.
Compliance statement (GAAP used)
Accounting policies
New accounting standards not yet in effect
Additional detail required by standards
Major underlying assumptions and
estimates
5. Additional disclosures
1. Contingencies: material events that have
an uncertain outcome
2. Guarantees
3. Segment reporting
4. Related party transactions
5. Economic dependence
6. Unrecognized contractual commitments
7. Financial risk management objectives and
policies
8. Subsequent events
Subsequent events
The or subsequent events period is the
period between the date of the statement
of financial position 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. Adjusting events 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. Non-adjusting events provide information
about conditions that did not exist and do
not require adjustment to the financial
statements. This information will affect
next year’s financial statements and
should be disclosed. Examples include:
• Fire or flood
• Decline in value of investments
• Issues of share capital or long-term debt
Non-adjusting events that do not require
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 end
2. Introduction of new product line
3. Loss of assembly plant due to fire
4. Sale of significant portion of company assets
5. Retirement of company president
6. Prolonged employee strike
7. 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
shares
9. Material loss on year-end receivable because of
a customer’s bankruptcy
10. Hiring of a new president
11. Settlement of a prior year’s litigation against
the company
12. Merger with another company of comparable
size