AC4304 Financial Reporting Theory Presentation Casey Lau Gloria Ho Hayley Cheng

Virtues of Income Statement

Agenda Background Definition Usefulness to users Limitation Recommendation

Background

Objectives Financial Statements “to provide information that is useful to users of assessing the financial position … … and the performance and cash flows of an enterprise ……” (HKSA Stm. 2.01)

Objectives Income Statement “…… while information about performance is primarily provided in a profit and loss account ……” (HKSA Stm. 2.01) “The financial statement of a firm that summarizes revenues and expenses over a specified time period.” (The 'Lectric Law Library's Lexicon)

Functions Profitability Past year’s operating results Underlying accounting concept Accrual / Matching

Main Items in I/S Turnover Cost of sales Gross profit Other revenue Distribution / Administrative / Other operating expenses P/L from operation Finance cost Share of P/L of associates / joint ventures Tax expenses P/L from ordinary activities Extraordinary items Minority interest Net P/L for the period

Usefulness to Investors

Investors are ... Equity security holders providers of risk capital concerned with the risk & return on investments

Investors need …… to know if they should buy, hold or sell. to assess the enterprise’s ability to pay dividends i.e. Reward of ownership

Profitability Profits as measure of performance Ratios analysis : - Profit margin - Return on assets - Dividend payout ratio - Earnings per share (EPS)

Comparability Corresponding prior year’s information Development trend Comparison : - Year-to-year - Enterprise-to-enterprise - Industry-to-industry

Control of Cost GP margin VS NP margin Comparative figures of expenses - e.g. Financial cost Future prospect like capital gains ?

Usefulness to Creditors

Creditors are …… Trade creditors : - Supplier of goods & service Non-trade creditors : - Customers & employees with claims - Lending institutions & individuals; - Debt security holders.

Creditors need …... information that enables them to determine whether amounts owing to them will be paid when due i.e. Solvency interested in an enterprise continuation of the enterprise as a major customer.

Solvency If enterprise can meet short-term & long-term obligation - Finance costs e.g. interest expense - operating profits

Going-concern The continuousness of the company by comparative figures Profit / Loss ?

Separate Items Impairment Items Finance costs Operating profits Balance Sheet as a supplementary tool

Usefulness to Managers

Mangers are …… Managers are basically those who run the firm on behalf of the shareholders. They are expected to act in the best interest of the shareholders. For the managers, income statements are published as a compliance of the Accounting Standards and the law.

Profitability They are concerned about the profitability and the company’s performance. Income Statement Predict Future Growth, Profits Share Price

Channel of Communication Income statements also serve as their channel of communication with the investors and to attract more investors.

Channel of Communication According to George Staubus, Professor of University of California, Berkeley in the ‘Investor Theory’ – “accounting/financial statements is to provide information to the firm’s suppliers of capital…..help them ascertain the firm’s willingness to pay investors.” Attract investors

Ability Assessment Income statements very often also serve as a means to assess managerial ability and their remunerations are tied to the current year earnings. “Famous scholars Paton & Littleton says in their definition of income: ‘…. It reflects managerial effectiveness and is of particular significance to those who furnish the capital and take the ultimate responsibility.”

Planning and Control Income statements (published accounts) can be used for internal control but normally managers mainly rely on the management accounts. Act as a monitoring tool with the support of budgeted I/S and comparison between actual and planned performance.

Limitation of the use of Income Statements

Limitations Information asymmetry Due to adverse selection, not all information are available to the investors in the income statements. Hence, income statements may not be able to reflect the full picture.

Limitations Earnings management & Income smoothing manipulation of accounts intentional dampening of fluctuations about some level of earnings that it currently considered to be normal for a firm e.g. by classification, recognition, allocation of time, etc. (Ronald D Picur; JBFA) MAY NOT BE THE TRUE PICTURE !

Limitations Agency relationship Results in agency costs Stockholders/investors Exist whenever a principal hire somebody else to act on its behalf as an agent Agency relationship Results in agency costs Income statements may not be able to reflect the firm’s real stability or potential to make profit. e.g. consume perquisites Creditors (Michael C. Jensen) e.g. increase level of debt or take high risk projects which are unanticipated by creditors

Recommendation

Comprehensive Income Theory all-inclusive income According to Financial Accounting Standards Board (FASB) SFAS 130: ‘Comprehensive income is the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes net income and other comprehensive income such as foreign currency translation adjustments, unrealized gains and losses, etc.

Comprehensive Income Theory Advantages: (Stan Clark, University of Southern Mississippi) Net income of the firm for the life of the firm should be equal to the sum of the annual report net incomes Income smoothing may be checked by the inclusion of all income changes and credits A better picture of the total performance of the firm is conveyed, especially when both recurring and unusual, infrequently occurring items are displayed separately in the income statement.

Value-added income statement Evaluate the firm in terms of its contribution to the society and the cooperative effort between the employees, suppliers of fund, & the government. Basis of theory: The above mentioned parties should cooperate together in order for a firm to survive and to make profit.

Value-added income statement (Waino Suojanen, Accounting Review) Performance measure of wealth creation by the firm, reflect more information e.g. social change (Michael Morley, The Value Added Statement, London)

Conclusion

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