today monday 1/24 finish ch 4, 17, 21 dq levitt and brennan wed 1/26 quiz #2 on p&l (no...

Today Monday 1/24 Finish Ch 4, 17, 21 DQ Levitt and Brennan

Wed 1/26 Quiz #2 on P&L (no scantron needed) Chapter 5 B/S and SCF

AgendaAgenda

Lists the following for a firm over a period of time:Ongoing Activities

Revenues Expenses

Incidental or Peripheral Activities: Gains Losses

The excess of revenues and gains over expenses and losses is equal to net income for the period. US GAAP vs. IFRS:

IFRS requires at least one year of comparative data on income statement (IAS 7)US GAAP has no specific requirement (however, SEC rules require firms to report 3 years of income statement data)

Chapter 4Chapter 4The Income StatementThe Income Statement

Evaluate past performance of a companyFeedback value

Provide a basis for predicting future performancePredictive value

Assist in assessing the risk or uncertainty of future cash flows

Predictive value

Usefulness of the Usefulness of the Income StatementIncome Statement

Does not report items that cannot be measured reliably Examples of excluded items?

Reported income is a function of the accounting choices made

Examples of accounting choices?

Managers exercise judgment in measuring income – can lead to earnings management:

Managers timing reporting of revenues, expenses, gains and losses to meet their incentivesGenerally increase current NI which decreases future NI Can also be used to decrease current NI in order to increase future NI

Limitations of the Income Limitations of the Income StatementStatement

Examples:

Dell

Enron

Worldcom

The Income Statement – The Income Statement – Earnings ManagementEarnings Management

The single-step statement consists of just two groupings:

I ncome Statement (in thousands)

Revenues:

Sales 285,000$ I nterest revenue 17,000

Total revenue 302,000 Expenses:

Cost of goods sold 149,000 Advertising expense 10,000 Depreciation expense 43,000 I nterest expense 21,000 I ncome tax expense 24,000

Total expenses 247,000 Net income 55,000$

Earnings per share 0.75$

Revenues

Expenses

Net Income

Single- Single- StepStep

Single- Single- StepStep

No distinction between Operating and Non-operating categories.

Single-Step Income Single-Step Income StatementStatement

The presentation divides information into major sections.

The presentation divides information into major sections.


Sales 285,000$

Cost of goods sold 149,000 Gross profi t 136,000

Operating expenses:

Advertising expense 10,000 Depreciation expense 43,000

Total operating expense 53,000 I ncome from operations 83,000

Other revenue (expense):

I nterest revenue 17,000 I nterest expense (21,000)

Total other (4,000) I ncome bef ore taxes 79,000 I ncome tax expense 24,000 Net income 55,000$

Earnings per share 0.75$

1. Operating Section

1. Operating Section

2. Nonoperating Section

2. Nonoperating Section

3. Income tax 3. Income tax

Multi-Step Income Multi-Step Income StatementStatement

Operating Section:• Contains information about the operating activity of a business• Used as basis for extrapolating into the future• May include unusual gains and losses

Non-operating Section:• Interest expense and revenue • Other gains and losses• May include unusual gains and losses

Income Tax Section:

Irregular Items Section: presented “Net of Tax”• Discontinued operations • Extraordinary items• Net of tax

Multi-Step Income Statement Multi-Step Income Statement PresentationPresentation

I nterest expense (21,000) Total other (4,000)

I ncome bef ore taxes 79,000 I ncome tax expense 24,000 I ncome from continuing operations 55,000

Discontinued operations:

Loss from operations, net of tax 315

Loss on disposal, net of tax 189

Total loss on discontinued operations 504

I ncome before extraordinary item 54,496

Extraordinary loss, net of tax 539

Net income 53,957$


Sales 285,000$

Cost of goods sold 149,000

Reporting when both Discontinued

Operations and Extraordinary Items

are present.

Discontinued Operations

(specify $ or % of tax)

Discontinued Operations


Extraordinary Item


Extraordinary Item


Irregular ItemsIrregular Items

Basic criteria (SFAS 144):

1. Results of operations and cash flows of a component of a company have been (or will be) eliminated from ongoing operations *

2. No significant continuing involvement in that component after disposal transaction *

Two important dates in reporting discontinued operations:•Measurement date (when management commits itself to a plan of segment’s disposal)•Disposal date (the date of sale of the segment).

• The time between the measurement date and the disposal date is often called the phase-out period

Reporting Irregular Items: Reporting Irregular Items: Discontinued OperationsDiscontinued Operations

Presentation:

1. Writedown of assets to “fair value less costs to sell” if less than carrying value. No “write-up” recorded if fair value greater than carrying value.

2. Results of operations for both current and prior periods are required to be reported as part of discontinued operations.

Both items are reported “net of tax” (i.e. “below the line”).Separate line item for tax expense (benefit)

Narrative – “less applicable tax expense (benefit) of $xxx” or xxx%

Refer to footnote on the face of the Income Statement

Reporting Irregular Items: Reporting Irregular Items: Discontinued OperationsDiscontinued Operations

Time Line for Discontinued Time Line for Discontinued OperationsOperations

Measurement Date

Year-end Final Disposal

Loss from Operations

(B)

Year-end

Prior year: reclassify into loss from op.

(A)

Part of Loss on Disposition

(C)

Part of Loss on Disposition: estimate

future disposal costs and accrue (D)

Combine actual portion (C) + estimated portion (D) = Loss on Disposition on I/S

Example: Albertson’s Example: Albertson’s (2003)(2003)

January 30, 2003 January 31, 2002Earnings from continuing operations before taxes 1,405 863Income tax expense 540 367--------------------------------------- ----------------- -----------Earnings from continuing operations 865 496 Discontinued operations:Operating (loss) income (50) 10 Loss on disposition (379) - Tax (benefit) expense (143) 5 ------------------------------------- ----------------- -----------Net (loss) earnings from discontinued operations (286) 5

1. Definition of component (IFRS 5)US GAAP is less restrictive than IFRS definition (IFRS: a reportable business or geographical segment or major component thereof)

2. Continuing Involvement (IFRS 5) IFRS does not address continuing involvement

3. Taxes (IFRS 5)US GAAP requires both pre-tax and post-tax income /loss to be disclosed on face of income statement

IFRS requires only post-tax income or loss to be disclosed

Discontinued Operations: US GAAP vs. IFRSDiscontinued Operations: US GAAP vs. IFRS

Extraordinary items must meet BOTH of the following criteria:1. Event/transaction must be unusual in nature.

2. Event/transaction must occur infrequently.

Items are reported “net of tax” (i.e. “below the line”).

Items that are NOT Extraordinary Items under GAAP:• Losses from write-down or write-off of receivables, inventories, etc.

• Gains and losses from:

–Exchange or translation of foreign currency

–Disposal of a segment of a business

–Abandonment of property used in business

• Effects of strike

• Adjustments or accruals on long term contracts

Extraordinary Item classification not allowed under IFRS

Reporting Extraordinary ItemsReporting Extraordinary Items

Verizon Communications:In January 2007, the Bolivarian Republic of Venezuela declared its intent to nationalize certain companies, including CANTV. On February 12, 2007, we entered into a Memorandum of Understanding (MOU) with the Republic. The MOU provides that the Republic will offer to purchase all of the equity securities of CANTV, including our 28.5% interest…at a price equivalent to $17.85….Based on the terms of the MOU and our current investment balance in CANTV, we recorded an extraordinary loss on our investment of $131 million, net of tax, or $.05 per diluted shares, in the first quarter of 2007.

Extraordinary Item ExampleExtraordinary Item Example

Unusual gains or losses:

Restructuring Charges

Gains or losses that are generally unusual or infrequent, but not both. Do not qualify as “extraordinary” must be reported above the line in either operating or non-operating section

of the income statement. This is an area where managers exercise discretion in presentation. Example: AOL P&L and Note 9

http://www.sec.gov/Archives/edgar/data/1468516/000119312510045310/d10k.htm

Reporting Reporting Unusual Gains or LossesUnusual Gains or Losses

Categories of Accounting Changes:

1. Change in Accounting Estimate

2. Accounting Errors in Financial Statements

3. Change in Accounting Principle

Accounting ChangesAccounting Changes

What possible ways can we handle these changes?

1.

2.

3.

Accounting Changes Accounting Changes

Application of certain accounting concepts requires estimates: Matching concept requires an estimate of the life of long-lived assets

Examples: uncollectible accounts, warranty liabilities, depreciation.

Estimates updated as new information becomes available.

Reporting: Reported prospectively.

Change reported in current and future periods

No effect on prior periods

Reported in the affected accounts, NOT “below the line”

Change in Accounting Change in Accounting EstimateEstimate

Example of prospective treatment: Purchase machine on 1/1/05 for $110,000 with an estimated

useful life of 10 years and a salvage value of $10,000.

Due to technological changes in 2006, it is estimated that the machine will have zero salvage value and will only have a useful life of 4 years beyond 2006. 2006 depreciation and beyond will be:

Change in Accounting Change in Accounting EstimateEstimate

Includes:

Change from an accounting principle that is not GAAP to GAAP. Mathematical mistakes Changes in estimate that occurs because estimates not prepared in good

faith or facts used in error Oversights (ex: failure to accrue or defer expenses and revenues at end of

period)

Reporting:

Reported retrospectively as a “restatement”

Correct error in year(s) originally made by a direct entry to the affected line item(s). In following years the effect flows through beginning R/E. If error prior to years presented, just adjust beginning R/E.

Errors from previous periods do not flow through current period income.

Accounting Errors in F/SAccounting Errors in F/S

Example: ABC company’s auditor found the following errors during the 12/31/10 audit. What is the impact of each error? Assume ABC is public.

(1) At the end of 2009, sales salaries of $45,000 were not accrued.

(2) In 2010, the company wrote off $87,000 of inventory considered to be obsolete; this loss was charged directly to Retained Earnings and credited to inventory.

(3) 2007 depreciation was understated by $100,000. Subsequent years’ depreciation was correctly recorded

Accounting Errors in F/SAccounting Errors in F/S

Voluntary adoption of different acceptable accounting principle Common example is LIFO/FIFO/Weighted Average Inventory costing

Must demonstrate that newly adopted principle is preferable

Treat retrospectively. Need to restate prior years f/s for new method Prior years’ statements presented in the financial statements are recast on a

basis consistent with the newly adopted principle.

Adjust beginning retained earnings for the earliest year presented to reflect any cumulative effect on periods prior to those presented.

Mandated change in accounting principle Generally new standards require a retroactive approach unless it is impracticable

If impracticable or choice given to issuer, can report cumulative effect of change as a separate net of tax line item on the Income Statement

Example stock options

Change in Accounting Change in Accounting PrinciplePrinciple

Example: Mattke Co. (a non-public company) began operations in 2005 and adopted weighted average pricing for inventory. In 2008, Mattke changed to FIFO pricing. Net Income data is:

Net Income Net IncomeYear Wt’d Ave. FIFO 2005 370,000 395,0002006 390,000 430,0002007 410,000 450,0002008 460,000 430,000

How is this reported? Retrospectively, prospectively, currently? Steps to report change.

1) Provide 3 years comparative P&L using restated amounts2) Provide 2 years comparative B/S using FIFO inventory value and restated Retained Earnings3) Restate 2006 beginning Retained Earnings to reflect $25,000 higher net income from 2005

What were the journal entries that made the above happen (ignoring taxes)?

Change in Accounting Change in Accounting PrinciplePrinciple

• Basic EPS

• Diluted EPS

• Firms required to disclose both basic and Diluted EPS

Earnings Per ShareEarnings Per Share

Computed as:

Net Income less Preferred Dividends Weighted Average of Common Shares Outstanding

Disclosed on the I/S for all the major sections:– Income from continuing operations– Discontinued operations loss, net of tax – Income before extraordinary item– Extraordinary item, net of tax– Net income


Example:•Assume NI of $5K•Pfd Stk Dividends = $1K•12/31/06 year-end•Outstanding common shares as follows:

– 1/1/06: 100 shares– 4/1/06: 200 shares– 7/1/06: 250 shares

Weighted Average Calculation:


Example: At 12/31/06 Shi Corp. had the following stock outstanding:

10% cumulative preferred stock, $100 par, 107,500 shares $10,750,000

Common stock, $5 par, 4,000,000 shares 20,000,000

During 2007, Shi Corp. did not issue any additional common stock. The following also occurred during 2007:

Income from continuing operations before taxes $23,650,000

Discontinued operations (loss before taxes) $ 3,225,000Preferred dividends declared $ 1,075,000Common dividends declared $ 2,200,000Effective tax rate 35%

Compute EPS as it should appear on the 2007 f/s.


• Increased by net income and decreased by net loss and dividends for the year.

• Prior period adjustments to beginning balance– Corrections of errors in prior period financial

statements

– cumulative impact of changes in accounting policy

• Any part of retained earnings appropriated for a specific purpose is shown as restricted earnings.– So dividends can’t be paid out from restricted R/E (can

be part of a debt covenant)

Retained Earnings Retained Earnings StatementStatement

What is comprehensive income?• All changes in equity during a period, except those

resulting from investments by or distributions to owners.

• Includes “regular” net income

• PLUS “other comprehensive income”:– unrealized holding gains or losses on securities (Ch17)

– unrealized gains or losses on foreign currency translation

– unrealized gains or losses on pension obligations

• Other items are presented “net of tax”

Comprehensive Income Comprehensive Income OverviewOverview

• Why do companies invest in debt and equity securities?

• < 20% interest assume little or no influence over investee

• Report debt intending to hold at “held to maturity”– Record investment at amortized cost

– Record interest as income

• Report equity & other debt investment using fair value method– Mark investment to “market” on B/S.

– Recognize unrealized gain or loss. Where depends upon classification• Trading Income Statement

• Available-for-Sale Other comprehensive income

• Other issues– Can calculate gain or loss at the portfolio level

– Potential for earnings management here?

Unrealized Holding Unrealized Holding Gains/Losses on SecuritiesGains/Losses on Securities

Example: on 1/1/09 Big bought shares of Little for $100,000. The shares were < 20% of the total outstanding stock of Little Company. On 12/31/09 the shares had a fair value of $125,000. Little paid dividends of $1000 to Big. How is this accounted for at 1/1/09 and 12/31/09?

• If classified as Trading Securities?

• If classified as Available for Sale Securities?

Do E17-7

Unrealized Gains/LossesUnrealized Gains/Losses

Presentation of Comprehensive income• Must be displayed as:

– A separate statement of comprehensive income –OR-

– Combined income statement and comprehensive income statement –OR-

– Part of statement of stockholders’ equity (most companies put it here)

– May present net of tax or before tax with a single line reporting taxes on comprehensive income

Do E4-14, E4-15

Presentation of Presentation of Comprehensive IncomeComprehensive Income

today monday 1/24 finish ch 4, 17, 21 dq levitt and brennan wed 1/26 quiz #2 on p&l (no...

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