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

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

Financial Reporting Business Model identifies three activities: Financing Obtaining cash funding Investing Use of funding to obtain resources Operating Use of resources to generate profits Financial statements should capture these fundamental business activities

Overview of the Business Model

Financial Reporting Balance Sheet Reports financing and investing activities Income Statement Reports operating and performance related activities Statement of Cash Flows Reports interrelationship between all three activities

Uses and Limitations of the Income Statement 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

Quality of Earnings The reliability of the information presented is dependent on the quality of earnings Characteristics of high quality earnings: 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

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

Single-Step Income Statement Presents only two groupings before Income before Discontinued Operations: Revenues (includes gains) 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

Single-Step Income Statement Revenues Net Sales Other Revenues (e.g. Dividend, Rental) Revenues – Expenses Cost of Goods Sold Selling Expenses Administrative Expenses Interest Expense Income Tax Expense Expenses = Net Income Any Gains/Losses from Discontinued Operations and Extraordinary Items must be disclosed separately from Continuing Operations Earnings per Share

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

Multiple-Step Income Statement Operating section Nonoperating section Income tax Continuing Operations Income/Loss from operations Gain/Loss from disposition Both reported net of taxes Discontinued Operations Material gains/losses Reported net of taxes Extraordinary Items Includes other gains/losses not included in net income Other Comprehensive Income

Continuing Operations–Detail Net Sales Cost of Goods Sold Selling Expenses Administrative or General Expenses Operating Section Other Revenues and Gains Other Expenses and Losses Nonoperating Section Separate income tax section on Income from Continuing Operations only Income Tax

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

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”

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

Reporting Irregular Items Income measurement currently follows a modified all-inclusive approach Most irregular items included in income except for the following: Prior years’ income errors 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

Reporting Irregular Items- Discontinued 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

Reporting Irregular Items- Discontinued 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

Discontinued Operations- Asset 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

Discontinued Operations- Asset 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 non- current Under IFRS, held for sale assets generally classified as current

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 $ x Earnings per share from discontinued operations x Earnings per share on net income $ x

Extraordinary Items Characteristics: Material amounts Non-recurring items Differ significantly from the typical business activities Three qualifying criteria (all three must be met): Infrequent Atypical of normal business activities 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

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

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)

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

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: Income from continuing operations Discontinued operations Extraordinary items [not allowed under IFRS] Other comprehensive income

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

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

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.

IFRS - Statement of Changes in Equity This statement presents the following: Total comprehensive income For each component of equity, the effects of retrospective application/restatement 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

Comprehensive Income Statement Example of a combined income and comprehensive income statement: Sales 800,000 Cost of goods sold 600,000 Gross profit 200,000 Operating expenses 90,000 Net income 110,000 Other comprehensive income Unrealized holding gain, net of tax 30,000 Comprehensive income 140,000

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

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

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