Chapter Four – The Income Statement and Statement of Cash Flows
Income Statement (aka Statement of Operations, Statement of Earnings, Profit & Loss)
· Summarizes the profit-generating activities that occurred during the reporting period.
· Earnings Quality – The ability of the reported earnings to predict the company’s future earnings. Analysts try to separate a company’s transitory earnings and permanent earnings.
o Transitory earnings represent transactions which are unlikely to occur again in the near future.
o Some categories to examine:
o Restructuring Costs – Not uncommon to declare, shows costs of a restructuring or reengineering program. Prior to 2003 would expense anticipated costs in current period and record a liability, but the SEC became wary of how regular these expenditures were being declared (could have negative expenses). SFAS No. 146 prohibits management from recognizing a liability before a cost associated with an exit or disposal activity unless a liability has actually been incurred. The Standard also stated the objective should be to record the fair value of the liability (the present value: time value of money)
o Goodwill Impairment/Long-Lived Asset Impairment – Any operational asset should be written down when there has been a significant impairment in value (tangible or intangible)
o Pro Forma Earnings – Management will often present an assessment of earnings which they view as permanent, which normally excludes expenses, such as restructuring, acquisition charges, and certain intangible amortization. Sarbanes-Oxley requires that if pro forma statements are provided with any SEC or public report that the company reconcile the earnings to those determined through GAAP.
· Earnings Smoothing
o Debate about how GAAP allows for the flexibility for management to manipulate earnings to make them appear less volatile, meet earnings, etc.
o This is a common practice used to meet wall street expectations
o Managers may accelerate or delay the recognition of revenues or expenses (example – channel stuffing to raise sales)
o Managers may also reclassify certain expenses – for example from operating to nonoperating or from continuing operations to a special charge (restructuring is big – AT&T)
o Big Bath – If you are going to miss earnings, you might as well miss big.
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Income from Continuing Operations
· Revenues, expenses (including income tax), gains, and losses
o These are distinguished and exclude from those of discontinued operations
· Recall the definition of revenues and expenses. Additionally, recall the matching principle which explains the relationship between revenues and expenses.
o If a relationship cannot be established, then we expense in current period, allocate over multiple periods, or relate it to another future period.
· Gains and Losses result from peripheral activities (sale of equipment, building, and other items which are not part of normal operations).
· Distinguishing between Operating and Nonoperating
o Operating includes revenues and expenses directly related to the principal revenue-generating activities
o Nonoperating includes revenues, expenses, gains, and losses from peripheral activities (e.g. gains on investments, sale of long-term assets, interest revenue/expense
o Other Income is often used to classify nonoperating activities
· No specific standards indicate how income from continued operations must be displayed. Two main types with many variations:
o Single-Step (Simple) – Revenues and Gains are grouped and Expenses and Losses are grouped, then subtracted from each other (i.e. no separation between operating and nonoperating)
o Multiple-Step (Useful for Analysis) – Operating and Nonoperating are distinguished, plus various subtotals are calculated (gross profit, operating income, and earnings before taxes)
Specifically Reported Items
· Only two items are allowed and mandated to be reported below income from continuing operations: Discontinued Operations and Extraordinary Operations.
· Discontinued Operations must be listed first, followed by Extraordinary Operations. Both are normally reported net of tax.
· There used to be a third item: Cumulative Effect of a Change in Accounting Principle, where an accounting change would be shown as one lump sum effect in the current year. In 2005, it was determined that changes in accounting principles would be handled retrospectively (i.e. restate the numbers as if it had been the new way all along).
· Discontinued Operations:
o If a component of an entity has been disposed of or is classified as held for sale, we report the results of its operation separately in discontinued operations, IF:
o 1) Operations and cash flows of the component have been/will be eliminated from ongoing operations
o 2) The entity will not have any significant continuing involvement in the operations of the component after the disposal transaction
· Extraordinary Items:
o An unusual event which materially affects the current period’s income, but it highly unlikely to occur again
o Reported separately, net of tax
o Unusual in nature and infrequent in occurrence.
o Use professional judgment for this subjective category
o The loss of a major client/death of CEO/strikes/competition are not extraordinary items as they are usual risks of operations
o Also, the definition may vary (e.g. hurricane damage in Florida vs. hurricane damage in Maine)
· Unusual or Infrequent Items
o Material events which are unusual in nature OR infrequent, but not both as defined by extraordinary items, should be listed in continuing operations, but be separated out
Income Tax Expense
· Always reported separately due to size and significance.
· When tax rules and GAAP differ regarding the timing of revenue or expense recognition, the actual payment of taxes may occur in a period different from when income tax expense is reported in the income statement. You would record a differed tax asset or liability as appropriate.
Comprehensive Income
· Debate over what should be included in Net Income
· FASB decided to maintain traditional view of net income calculation, but also expand to show Comprehensive Income. Four Categories:
o Net unrealized holding gains (unrealized gains/losses on investments marked to the market)
o Minimum Pension Liability Adjustments
o Deferred gains/losses from derivatives
o Currency Translation Adjustments
· May be reported net of tax or before tax with a separate tax line.
· May be reported in (Income Statement, Changes in Shareholder’s Equity <Majority>, as a separate statement, or even a disclosure statement)
· Accumulated comprehensive income is recorded in the equity section of the Balance Sheet as Accumulated Other Comprehensive Income
Accounting Changes:
· Changes in Accounting Principle
o Example – Change from LIFO to FIFO or revenue recognition
o Retrospectively restate prior year financial statements to allow for comparability and consistency
· Change in Accounting Estimate
o When changing an estimate, do not revise prior year financial statements
o Change is treated prospectively
· Change in Depreciation, Amortization or Depletion Methods
o Viewed as a change in accounting estimate
o Treat this prospectively
o Example of Equipment half way through
Correction of Accounting Errors:
· Errors discovered in the same year
o Original erroneous journal entry should be reversed and the correct entry be recorded.
· Errors discovered in a subsequent year
o Depends on materiality
o If minor (which is the majority) then correct in current year
o If major, then have a Prior Period Adjustment – an adjustment to retained earnings to account for error. Additionally, financial statements affected by the error are retrospectively restated. Finally, it should all be defined in a disclosure note
Earnings Per Share Disclosure:
· Basic EPS – Divide net income by the weighted average number of common shares outstanding during the period
· Diluted EPS – Factors in for the potential dilution for stock option and other compensation packages
Statement of Cash Flows
· Covers the change in Cash and Cash Equivalents over a period of time.
· Direct vs. Indirect Method
o Affects only the operating activities section
o Direct Method – the cash effect of each operating activity is reported directly in the statement
o Indirect Method – starts with net income and works backward to the cash basis. Two types of adjustments – the reversal of non-cash items figured in net income and the adjustment to factor for increases of decreases in assets and liabilities.
· Three Categories:
· 1) Operating Activities
o Cash inflows and outflows from activities reported in the income statement
o Example – cash received from customers for sales and cash expended to purchase inventory
o Accrual revenues will typically not equal cash inflows and accrual expenditure will typically not equal cash outflows
o The difference between inflows and outflows of this category are called ‘net operating cash flow’ or ‘net cash flows from operating activities’
· 2) Investing Activities
o Cash flows related to the acquisition and disposition of long-term operating assets and investment assets.
· 3) Financing Activities
o Cash flows related to external financing of the company
o Includes the sale of our company’s stock and bonds and their repurchase
o What about interest?
o Also includes dividends
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