2. CHAPTERS 15 & 18 FINANCIAL REPORTING: Part 1: The Income Statement

3. INCOME STATEMENTS Additional Sections Additional sections follow below operating income; they are for reporting material items not typical of regular operations. These non-typical times include: 1.Non Operating Revenues and Expenses 2.Discontinued operations 3.Extraordinary items Each item should be carefully explained in notes to the financial statements, and the income statement should report the income tax expense or savings applicable to each item.

4. Any item that does not have anything to do with the regular business activities of the business. Examples include: –Minor “other” revenues –Interest expense –Gains and losses on the disposal of assets INCOME STATEMENTS 1. Non Operating Revenues and Expenses

5. INCOME STATEMENTS 2. Discontinued Operations Discontinued operations refers to the disposal of a significant segment of a business, such as the elimination of an entire activity or of a major class of customers. Income (loss) from discontinued operations consists of 1.Income (loss) from operations, and 2.Gain (loss) on disposal of the segment.

6. INCOME STATEMENTS 3. Extraordinary Items Extraordinary items are events and transactions that meet three conditions: 1.Infrequent 2.Non-typical 3.Not subject to management decision

7. INCOME STATEMENTS Extraordinary vs. Non-Extraordinary Extraordinary Items 1.Effects of major casualties (acts of God) if rare in the area 2. Expropriation (takeover) of property by a government 3.Effects of a newly enacted law or regulation, such as a condemnation action Ordinary Items (But not Operating Items) 1.Effects of major casualties (acts of God) if frequent in the area 2. Write down of inventories or write off of receivables 3.Losses attributable to labour disputes 4.Gains or losses from sale of capital assets

8. INCOME STATEMENTS Presentation – From Operating Income Onwards Non – Operating Items Other Revenues and Gains Operating Income Other Expenses and Losses Casualty Loss from Vandalism Total non-operating expenses and losses Total non-operating revenues and gains Less: Income Taxes (assume 40% tax rate) Income from real estate division, net of tax expense $504,850 $304,200 $3,000 241,200 277,200 (27,000) (36,000) Gain on sale of Equipment Interest Expense $(3,750) (5,000) (202,800) Interest Revenue $2,900 Net Income Discontinued Operations Total Income before Taxes Income before Extraordinary Items Loss from sale of real estate division, net of tax savings Income (Loss) on Discontinued Operations Expropriation of Property, net of tax savings Income from Continuing Operations 8,000 10,900 (8,750) $507,000 (30,000) $5,000 –$2,000 (40%) is… $50,000 –$20,000 (40%) is… (60,000) – 24,000 (40%) is…

9. HWA ENERGY, INC. Net income $301,000 Earnings per share Income from continuing operations Loss from discontinued operations Income before extraordinary item Extraordinary loss Net income INCOME STATEMENTS Earnings Per Share - Additional Disclosures When the income statement contains any non- typical item, EPS should be disclosed for each component. $5.60 (2.10) 3.50 (.49) $3.01

10. Prior Period Adjustments Whenever a change in an accounting policy or procedure is made (e.g. FIFO to LIFO), the effects on Net Income (net of tax) for all prior years is charged directly to Capital. –Capital Account (for sole proprietorships) –Retained Earnings (for corporations)

11. Prior Period Adjustments A business with a 6 year old machine, and a 40% tax rate, changes it’s amortization method from straight line to declining balance. This produces $40,000 of additional expense up to Jan. 1 of this year. It is shown in the Equity section as follows Begin. Balance Jan. 1 as previously reported $124,000 Retained Earnings Jan. 1 as adjusted $100,000 Ending Balance, Dec. 31 $160,000 Add: Net Income $80,000 Change in accounting policy net of $16,000 (24,000) in tax Less: Drawings/Dividends (20,000) Change in Equity for the year 60,000

12. Do Problems: P15-6A P15-7A

13. EARNINGS PER SHARE Earnings per share (EPS) indicates the net income earned by each common share. Companies report earnings per share on the income statement The formula to calculate earnings per share when there has been no change in shares during the year is as follows: Net Income – Preferred Dividends Number of Common Shares Earnings per Share 

14. PRICE - EARNINGS RATIO The price-earnings (P/E) ratio helps investors determine whether the shares are a good investment in relation to earnings. It is a per share calculation, calculated by dividing the market price of the shares by its earnings per share. A high P/E ratio can be one indicator that investors believe the company has future growth potential. Market price per share  Earnings per share Price-Earnings Ratio

15. FINANCIAL REPORTING: Part 2: The Statement of Changes in Financial Position, or The Cash Flow Statement, or the Statement of Cash Flows, or that statement that Boulton never taught us way back in grade 11 with eighteen versions of a really, really long damn name that I can’t even be bothered to remember so I’ll just call it whatever comes into my head. CHAPTERS 15 & 18

16. CASH FLOW STATEMENT Purpose Purpose To provide information about cash receipts and cash payments during the period Recall that accounting numbers are NOT cash based, they’re accrual based. The Cash Flow Statement reconciles these two values (i.e. it turns accrual Net Income into real Cash Flow). Note: we are only going to learn the “indirect method.”

17. CASH FLOW STATEMENT Purpose Purpose Achtungen! Items that affect PROFIT but not cash Items that affect CASH but not profit Sales on A/R Bad Debt Expense Inventory valuation (FIFO, etc) Revenue from significant investments Amortization (all kinds) LCM write downs Gains/Losses on sale of assets Changes in accounting policies Purchase of assets Investments in securities Redemption of investments Debt acquisition Debt repayment Stock issue (corp.) Dividends (corp.) Owner’s investment (sole prop.) Owner’s Drawings (sole prop.)

18. CASH FLOW STATEMENT What You Need CASH FLOW STATEMENT What You Need The cash flow statement is prepared differently from the other financial statements; it is not prepared from the worksheet/trial balance. Instead, you require the following information: 1. Comparative balance sheets (2 years) 2.Current income statement 3.Any additional information

19. Know that there are three sections to the Statement: 1.Operating activities 2.Investing activities 3.Financing activities CASH FLOW STATEMENT What You Need CASH FLOW STATEMENT What You Need

20. RULE OF THUMB: 1.If it was subtracted from profit but didn’t use cash, add it back 2.If it was added to profit but didn’t generate cash, deduct it. 3.If it doesn’t affect cash, don’t put it in the Cash Flow Statement! CASH FLOW STATEMENT The Process CASH FLOW STATEMENT The Process

21. Step 1: –Go through the comparative balance sheets and determine the value of all differences Step 2: –Start the Cash Flow Statement. Begin by listing Net Income. You’ll now convert this number to Net Change in Cash by doing the following: Step 3: –Place the differences (from Step 1) into the appropriate section (be sure to list properly as an increase/decrease to cash) Step 4: –Complete the statement by taking any additional information into account. This may require adjustments to Step 3. CASH FLOW STATEMENT The Process

22. Start with your NET INCOME figure. –All changes will be made to this figure. –You’ll be converting it from an ACCRUAL number, into a CASH number. –We do it this way so we have at least something to start with, otherwise we’d have to start at zero and adjust for every transaction for the year. CASH FLOW STATEMENT Step 2.

23. Operating activities include: –Regular business operations, i.e. the cash effects of transactions that create revenues and expenses Generally: CASH FLOW STATEMENT Step 3: Operating Activities From the Balance SheetFrom the Income Statement Current Assets: Current Liabilities: Since we start with the Net Income, revenues and expenses are already accounted for. Only non-cash revenues and costs are a concern. Examples include: Amortization Increase: add back Gains Increase: deduct Losses Increase: add back An increase is a USE of cash, deduct it. An increase is a SOURCE of cash, add it back. Revenue & Expense: Why? Example: Accounts Receivable Example: Accounts Payable

24. Investing activities include: –Purchasing and disposing of investments and capital (L-T) assets using cash, and –Lending others money and collecting on those loans Generally: CASH FLOW STATEMENT Step 3: Investing Activities From the Balance Sheet Capital Assets An increase in investments or other long-term assets is a USE of cash, deduct it. From the Income Statement Generally, items here are not a concern Additional information should tell you if you need to worry about Dividends Received for significant ownership (>20%), since they’re not recorded as revenue they must be added. Interest Revenue on money lent is already in Net Income.

25. Financing activities include: –Borrowing money from others and repaying the amounts borrowed, and –Obtaining cash from owners/shareholders and paying them drawings/dividends Generally: CASH FLOW STATEMENT Step 3: Financing Activities From the Balance Sheet Long-Term Debt and Equity An increase in debt or equity is a SOURCE of cash, add it. Dividends are a USE of cash, deduct. Note: if you’ve issued bonds or shares, you’ve probably used the funds to buy assets, so you’ll have entries under Investing Activities. From the Income Statement Generally, items here are not a concern. Note: Interest paid on bonds is an operating item and is already incorporated in the Net Income figure that you start with.

26. Remember: –You must take additional information into account (provided in question) Why? –Example: value of Land may change by $10,000 over the course of the year –However, this may be due to a purchase of $20,000 of new land, and a sale of $10,000 of old land. –Both activities need to be shown, not just the net change of $10,000 CASH FLOW STATEMENT Step 4: Additional Information

27. CASH FLOW STATEMENT What’s It Look Like? CASH FLOW STATEMENT What’s It Look Like? COMPUTER SERVICES COMPANY Cash Flow Statement — Indirect Method For the Year Ended December 31, 2002

28. A Cash Flow Statement tells you many things You need to learn how to spot red flags and understand their significance CASH FLOW STATEMENT What’s It Mean? CASH FLOW STATEMENT What’s It Mean?

29. Meaning of Significant USE of Cash in: Accounts Receivable –Giving credit to risky customers – bad debt –Not collecting quickly enough – week credit policies –Poor management of A/R department –Incompetence in A/R department Inventory & other Short-Term Assets –Purchasing too much inventory –Could be poor sales, bad forecasts, management incompetence –May be a result of lax controls in purchasing, or a sudden change in demand –Building up inventory in anticipation of business expansion CASH FLOW STATEMENT What’s It Mean? – The Operating Section CASH FLOW STATEMENT What’s It Mean? – The Operating Section

30. Meaning of Significant USE of Cash in: Accounts Payable –You’re paying of debt too quickly –Not taking advantage of credit granted –Not having a good credit rating and not being granted credit –Poor management in A/P department CASH FLOW STATEMENT What’s It Mean? – The Operating Section

31. Meaning of Significant USE of Cash in: Capital Assets –May signal a business restructuring –May indicate that many assets are old and need to be replaced –May signal an up-coming change in product lines or business focus –May be an indication of over zealous ambitions: buying far too expensive equipment, unnecessary purchases, etc. Investments –If investments rise, may be an indication that the company has very healthy cash flows, and can afford to invest in stocks/bonds –Increase in equity investments may indicate an intention of a takeover CASH FLOW STATEMENT What’s It Mean? – The Investing Section

32. Meaning of Significant USE of Cash in: Debt & Equity –Looking to purchase new assets or a new business –Indication of intention to expand in some way –Indication of a need to refinance debt (current loans have interest that is too high)…(look to see what’s going on in the investing section) –May be showing that company is short on funds and needs loans to keep itself a float (look at other areas of statement for clues) Dividends –May be paying out too much in dividends, drain on cash –Could be a result of poor decisions, demands/expectations of shareholders CASH FLOW STATEMENT What’s It Mean? – The Financing Section

33. Liquidity –Cash current debt coverage ratio Profitability –Cash return on sales ratio –Cash flow per share Solvency –Cash total debt coverage These ratios are cash-based instead of accrual-based CASH FLOW STATEMENT What’s It Mean? CASH FLOW STATEMENT What’s It Mean?

34. CASH CURRENT DEBT COVERAGE Cash current debt coverage indicates the amount of cash to pay off current debt that is generated from operating activities. The ratio provides a better picture of liquidity than using the current ratio because it uses cash provided by operating activities rather than the year-end asset balance. Cash Provided by Operating Activities Average Current Liabilities Cash Current Debt Coverage 

35. CASH RETURN ON SALES Cash return on sales indicates how quickly sales are turned into cash. The company is efficient at turning sales into cash when its cash return on sales is greater than its accrual-based counterpart, the profit margin. Cash Provided by Operating Activities Net Sales Cash Return on Sales 

36. CASH FLOW PER SHARE Cash flow per share indicates the cash flow generated for each common share. Cash Flow from Operating, Investing, and Financing Activities Number of Common Shares Cash Flow per Share 

37. CASH TOTAL DEBT COVERAGE Cash total debt coverage indicates the amount of cash to pay off total debt that is generated from operating activities. The ratio is the cash based counterpart to the debt to total assets ratio. Cash Provided by Operating Activities Average Total Liabilities Cash Total Debt Coverage 