1. Announcements Sammy Skateboard Results: 20 mean (25 points)
Quiz # 1 Results: 11.6 mean (17 points)
Project 1 due Monday 1/29 (extended from 1/24). Be prepared to discuss in class
Midterm 1 is Monday 2/5

2. The Income Statement
The income statement lists the following for a firm over a period of time:
Revenues
Expenses
Gains
Losses
The excess of revenues and gains over expenses and losses is equal to net income (or net loss, if negative) for the period. SEC rules requires firms to report 3 years of income statement data.

3. Usefulness of the Income Statement
Evaluate past performance of a company
Feedback value
Provide a basis for predicting future performance
Predictive value
Assist in assessing the risk or uncertainty of future cash flows

4. Limitations of the Income Statement
Does not report items that cannot be measured reliably (e.g. unrealized gains/losses on certain investment securities, intangible items such as brand recognition, customer satisfaction, product quality).
Reported income is a function of the accounting methods a company uses (e.g. different depreciation methods within GAAP).
Managers exercise judgment in measuring income.

5. The Income Statement – Earnings Management
Managers timing reporting of revenues, expenses, gains and losses to meet their incentives
Generally used to increase income in the current year at the expense of income in future years
Can also be used to decrease income in current year in order to increase income in future periods

6. The Income Statement – Earnings Management
Examples:
AOL Time Warner
Bristol-Myers Squibb
Enron
Worldcom
Xerox

7. Income Statement Elements
Ongoing Activities:
Revenues: increases in assets or decreases in liabilities
Expenses: decreases in assets or increases in liabilities
Incidental or Peripheral Activities:
Gains: increases in assets or decreases in liabilities
Losses: decreases in assets or increases in liabilities

8. Income Statement Presentation
Single-Step Income Statement:
Groups together all revenues and all expenses and Net Income is the difference between the two groups.
Used by approximately 25% of firms
No distinction between operating and non-operating activities
Eliminates potential classification issues

9. Single-Step Income Statement
The single-step statement consists of just two groupings:
Revenues
Expenses
Net Income
Single- Step
No distinction between Operating and Non-operating categories.

10. Income Statement Presentation
Multiple-Step Income Statement:
Divides information into major sections on the statement.
Differentiates between operating and non-operating activities.
Continuing operations are shown separately from irregular items. Income tax effects are shown separately as well.
Prepared with objectives of financial reporting in mind, particularly (1) enabling users to predict amounts, timing and uncertainty of future cash flows and (2) providing information on available resources and claims to those resources.

11. Multi-Step Income Statement
The presentation divides information into major sections.
1. Operating Section
2. Nonoperating Section
3. Income tax

12. Income Statement Presentation
Section 1 – Operating Section:
Contains information about the operating activity of a business.
Revenues from continuing operations
Cost of products sold or services performed
Other operating expenses
These items are grouped together because the activity underlying the numbers is likely to continue, and investors and others may wish to use information as basis for extrapolating into the future. May also include unusual gains and losses that occur relatively infrequently, but arise from the company’s ongoing operations.

13. Income Statement Presentation
Section 2 – Non-operating Section:
Contains information about interest expense and revenue and other gains and losses of the firm.
Separating interest expense provides information about claims on resources, since debt holders usually have priority claim over shareholders.
Other gains and losses relate to transactions that may or may not recur, and separating those items presumably allows users to more accurately reflect the future.

14. Income Statement Presentation
Section 3 – Income tax:
Deducts taxes - also provides information about claims on resources
Section 4 – Irregular items:
Relates to special items that are not expected to recur. The FASB believes that the nature of these items is such that they should be explicitly disclosed at the bottom of the income statement and reported net of tax consequences:
Discontinued operations
Extraordinary items

15. Reporting Irregular Items
Discontinued Operations
Basic criteria (see SFAS144 for more detail):
The results of operations and cash flows of a component of a company have been (or will be) eliminated from ongoing operations.
No significant continuing involvement in that component after disposal transaction.

16. Reporting Discontinued Operations
There are two important dates in reporting discontinued operations:
the measurement date (when management commits itself to a plan of segment’s disposal) and
the 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

17. Time Line for Discontinued Operations
Measurement Date
Year-end
Year-end
Final Disposal
Loss from Operations
(B)
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

18. Example: Albertson’s (2003)
January 30, 2003 January 31, 2002
Earnings from continuing
operations before taxes ,
Income tax expense
Earnings from continuing operations
Discontinued operations:
Operating (loss) income (50)
Loss on disposition (379)
Tax (benefit) expense (143)
Net (loss) earnings from
discontinued operations (286)

19. Reporting Irregular Items
Discontinued Operations
Presentation:
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.
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”).

20. Reporting Irregular Items
Extraordinary Items
Item must meet BOTH of the following criteria:
Event/transaction must be unusual in nature. Such items are of a significantly different character than typical business activities of the firm and would not normally be considered in evaluating operating results.
Event/transaction must occur infrequently. The transaction would not be expected to recur in the foreseeable future in the environment in which the business operates.
Items are reported “net of tax” (i.e. “below the line”).

21. Reporting Irregular Items
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.
Gains and losses on disposal of a segment of a business.
Gains and losses from the abandonment of property used in business
Effects of strike
Adjustments or accruals on long term contracts.

22. Reporting Irregular Items
Extraordinary Items:
The environment in which a firm operates is an important consideration in determining whether a gain or loss is extraordinary.
Hail damage may be considered to be extraordinary in certain locales, but not in others.
Frost damage in Florida does not qualify as extraordinary because happens every few years.
It is rare that events/transactions qualify for extraordinary reporting.

23. Reporting Irregular Items
Extraordinary Items:
Why does GAAP make it so difficult for a gain or loss to qualify as extraordinary?
How do you expect losses associated with Hurricane Katrina will be treated?

24. Reporting Irregular Items
Unusual gains or losses: Gains or losses that are material and typical of customary business activities. They are generally unusual or infrequent, but not both.
Reporting:
Do not qualify as “extraordinary” and 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.

25. Accounting Changes Categories of Accounting Changes:
Change in Accounting Principle
Change in Accounting Estimate
Errors in Financial Statements

26. Accounting Changes – 3 possible approaches to apply
Currently. Report cumulative effect of the change in the current period on current year income statement.
Retrospectively. Adjust prior years’ statements that are presented in the financial statements to reflect the newly adopted principle. Record any cumulative effect as an adjustment to beginning R/E for earliest period presented.
Prospectively. No change is made to previously reported results. No cumulative adjustment. Apply new principle on in current and future periods.

27. Accounting Changes Changes in Accounting Principles:
Company adopts different accounting principle from the one previously used (e.g. change in inventory pricing from FIFO to average costing).
Company must demonstrate that newly adopted principle is preferable to the old one since such changes mean consistency across periods is lost.
Previous reporting – Current approach was used. Cumulative effect of the change reported “below the line” with discontinued operations and extraordinary items. Prior years’ statements were not restated.

28. Accounting Changes Changes in Accounting Principles:
FAS154 (effective for fiscal years beginning after May 15, 2005) adopts retroactive approach.
Recognized by making a retroactive adjustment unless it is impracticable to do so.
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. (Note no cumulative effect is reported on the Income Statement).

29. Accounting Changes Changes in Accounting Estimates:
Application of certain accounting concepts requires the use of estimates. For example, the matching concept requires an estimate of the life of long-lived assets. Other estimates include uncollectible accounts and warranty liabilities. Managers may need to update these estimates as new information becomes available.

30. Accounting Changes Changes in Accounting Estimates: Reporting:
The effects of changes in accounting estimates are reported prospectively. Change is reported in the period of change and any future periods affected, with no consideration to revising/restating previous periods. Changes are reflected in the accounts affected and are not reported “below the line”.

31. Correction of Errors Examples:
Change from an accounting principle that is not GAAP.
Mathematical mistakes
Changes in estimate that occurs because estimates not prepared in good faith.
Oversights, such as failure to accrue or defer certain expenses and revenues at end of period.
Misuse of facts, such as failure to use salvage value in computing depreciation base for straight-line depreciation.
Incorrect classification of a cost as expense instead of an asset and vice versa.

32. Correction of Errors
Report corrections of errors as prior period adjustments (Restatement).
Record as a direct entry to retained earnings in the year in which the error was discovered.
Errors from previous periods do not flow through current period income.
Restate prior statements presented to correct for the error.

33. Intra-period Tax Allocation
Tax expense for year related to specific items.
Used for:
Income from continuing operations
Discontinued operations
Extraordinary items

34. Discontinued Operations
Irregular Items
Reporting when both Discontinued Operations and Extraordinary Items are present.
Discontinued Operations
Extraordinary Item

35. Earnings Per Share Basic EPS Diluted EPS
Companies required to disclose both Basic EPS and Diluted EPS

36. Basic Earnings Per Share
Earnings per share is:
Computed as:
Net Income less Preferred Dividends
Weighted Average of Common Shares Outstanding
Disclosed on the income statement for all the major sections.

37. Basic Earnings Per Share
Example:
Assume NI of $5K
PS Dividends = 0
12/31/06 year-end
Outstanding shares as follows:
1/1/06: 100 shares
4/1/06: 200 shares
7/1/06: 250 shares
Weighted Average Calculation:

38. Earnings Per Share
At December 31, 2006, Hertz Corporation 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 ,000,000
During 2007, Hertz Corporation 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) $ 3,225,000
Preferred dividends declared $ 1,075,000
Effective tax rate %
Compute EPS as it should appear on the 2007 f/s.

39. Retained Earnings Statement
Retained earnings are increased by net income and decreased by net loss and dividends for the year.
Corrections of errors in prior period financial statements are shown as prior period adjustments to the beginning balance in retained earnings.
And changes in accounting policy are treated retroactively, so opening R/E is also adjusted for the cumulative impact
Any part of retained earnings, appropriated for a specific purpose, is shown as restricted earnings.
These restrictions merely mean you can’t pay out dividends from restricted R/E (can be part of a debt covenant)

40. 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
unrealized gains or losses on foreign currency translation
unrealized gains or losses on pension obligations
(This is discussed in more detail in Chapter 17, investments)

41. Other 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)

42. Other Comprehensive Income
A = L + OE
OE = CC + RE + AOCI
AOCIend = AOCIbeg + OCI
REbeg + NI – DIV = REend
OE = CC + REbeg + NI - DIV + AOCIbeg + OCI