Chapter Four

IFRS Income definition

"income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increase in equity, other than those relating to contributions from equity participants". -includes "gains" from secondary activities rather than from the firm's primary business activities.

comprehensive income

"the change in equity of a firm during a period from transactions and other event and circumstances from non-owner sources. It includes all changes in equity during the period except those resulting from investments by owners and distribution to owners". -certain items of revenue and expenses that are excluded from the net income calculation. COMPREHENSIVE INC= NET INCOME + OTHER COMPREHENSIVE INCOME.

Income statement analytical issues

*the analyst needs to determine whether an item classified by management as "nonrecurring" are includable as future elements of gain or loss. -restructure charges (P&G -annual) -retirement of fixed assets and the recognition of gains/losses (car rental agencies and annual fleet retirement).

EPS Reporting

-A company with a complex capital structure must report both: (basic and dilutive EPS) -in addition the impact of the following effects must be shown on a per share basis: (discontinued activities, extraordinary items, cumulative effect of accounting policy changes).

Revenues (sales)

-Are the amounts reported from the sale of goods and services in the normal course of business. SINGLE STEP FORMAT: only operating income shown. MULTI STEP FORMAT: gross profit (rev-cogs) is shown as a line item.

Barter Sales

-Co. A exchanges one product for another product from co. B but no cash changes hands, can either party report revenue? -Fair value of the transaction is the question -IFRS- revenue must be based on fair value revenue from similar non-barter transactions. -GAAP: revenue is recognized only if a company has historically received cash payments.

percentage of completion (POC) vs. completed contract (CC) method

-NET INCOME: will be HIGHER each year for POC because CC does not recognize revenue until project completion. -INCOME VOLATILITY: is GREATER with CC method because POC recognizes some revenue and partial income each year instead of recognizing it all at one time. -CASH FLOW: is the SAME for both (CF is unaffected by the revenue recognition method used)

Expenses

-amounts incurred to generate revenue such as COGS, operating expenses, interest and taxes. -expenses are grouped together by their nature or function. EX: all depreciation, costs associated with manufactoring, raw materials, or COGS.

Doubtful accounts/warranties

-as a firm sells products and services on credit, some customers may not pay in full or at all and default on their obligation. -direct write off method -not GAAP -matching principle requires periodic estimates of expense to match revenue. -estimate based off prior experience. -recognition as an expense on I/S NOT as a direct reduction of revenue.

treasury stock method

-assumes that the hypothetical funds received by the company from the exercise of the options are used to purchase shares of the company's common stock in the market at the average market price. -reduces the total increase in shares created from the hypothetical exercise of the options into common stock. -the net increase in the number of shares outstanding will be the number of shares created by exercisting the options less the number of shares repurchased with the proceeds of exercise.

Percentage of completion (analytical issues)

-both buyer and seller have enforceable rights under the contract. -as a result, a continuous sale occurs as work progresses. Consequently, the percentage of completion method tends to smooth earnings and is a better measure of earning power but also a more aggressive accounting methdology. -this more aggressive method may overstate or recognize revenue and gross profit/income earlier if expenditures are recognized before they contribute to completed work (think denominator) 1. include raw material costs within expenses before work is completed. 2. Include advance payments to sub contractors as expenses before work begins.

Treasury Stock Method

-calculates what the diluted EPS would have been if the options had been exercised and the company had used the cash proceeds received from exercise to repurchase the common shares. -assumes the exercise of the options or warrants would bring cash into the firm at the beg. of the year. -assumes the cash is used to repurchase shares at the avg. stock market price for the year. if the exercise price < market price, then the proceeds from exercise are not sufficient to buy back all the shares. -no adjustment to the numerator -denominator is adjusted for the repurchased shares bought with the cash proceeds from the conversion

accounting changes: prior period adjustments

-correcting errors or changing from an incorrect accounting method to one that is acceptable under GAAP -typically requires restatement of prior period financial statements -must disclose the nature of the error and its effect on net income in footnotes.

extraordinary items

-defined as unusual and infrequent (US GAAP) -losses due to a foreign gov expropriation of assets -uninsured losses from natural disasters (casualty losses) -show after tax, BELOW THE LINE. -required to show EPS amounts -is the company really accident prone? YOY comparisons will help identify problems.

Amortization

-depreciation of intangibles -spreading cost over life -goodwill not amortized (annual impairment reviews) -if the earnings pattern can't be established, use straight line.

dilutive stock options, treasury stock method.

-dilutive only when the exercise price < average market price. -assume proceeds from sale of stock issued to buy back shares in the market at the average market price for the year. STEPS: -calculate the number of common shares created if the options are exercised. -calculate cash received from sale of stock -calculate number of shares that can be purchased at the average market price with sale proceeds. -calculate the net increase in common shares outstanding.

stock splits and stock dividends

-do not increase/decrease the net assets of the enterprise, the action only changes (increases) the number of common shares retroactively for the entire year. -additional shares issued or repurchased shares change the net assets of the firm from the date of occurrence. -do not change on owner's proportionate claim on the firm's earnings.

things to remember about dilutive securities

-each potential dilutive security must be examined separatley to determine if it is actually dilutive. The effect of conversion to common is only included in the calculation of diluted EPS for a given security if it is, in fact diluted. -Somethings there is a provision that the shareholders of the acquired company will receive additional share of the acquiring firms stock if certain performance targets are met. these contingent shares would be included in the calculation of diluted EPS if the target has been met as of the end of the reporting period.

Unearned revenue

-if a firm receives cash before revenue recognition is complete, -unearned revenue is reported on the balance sheet as a liability. The liability is reduced in the future as the revenue is earned -ex: magazine publisher receives subscription payments in advance of delivery -when payments are received, both assets (cash) and liability (unearned rev) increase. As the magazines are delivered, the publisher recognizes revenue in the income statement and the liability is reduced.

Cumulative effect of changes in accounting principle

-impact of change on prior period earnings is typically recorded on current income statement, net of taxes after net income (BELOW THE LINE) -this is not required for changes in accounting estimates -no longer applies under US GAAP and IFRS

convertible securities

-include bonds, warrants, and preferred stocks that can be converted to shares of common stock, thereby increasing the number of shares outstanding and diluting the EPS. -the "If converted method" measures the potential dilutive effect of the conversion on the EPS calculation. ASSUMES: -conversion of the securities at the beginning of the period -elimination of the related interest expense, net of tax

dilutive stock options and warrants

-increase the number of common shares outstanding in the denominator for diluted EPS. There is no adjustment to net income in the numerator. -They are dilutive only when their exercise price is less than the average market price of the stock over the year. -use treasury stock method to calculate adjustment to the number of shares in the denominator.

common sized income statement (relation of COGS, SG&A, and net income)

-increased COGS% suggests a lower selling price or higher cost of material and labor -increased SG&A% also suggests a lower selling price or higher costs in this area. -lower net profit margin% (net income as a % of sales) reflects a lower selling price or higher expenses.

components of net income below "the line"

-items below "net income from continuing operations" are show NET OF TAX since they will no longer contribute to the firm's future operating activities (discontinued operations, extraordinary items) -no longer allowed under US GAAP -cumulative effect of changes in accounting principle.

Minority Interest

-minority interest means a firm consolidates subsidiaries over which they have control -consolidation menas they include all of the revenue and expenses of the subsidiary even if they own less than 100% -the amount shown on the face of the I/S represents the potion of income belonging to the minority shareholder.

Sales basis method

-most commonly used revenue recognition Revenue is recognized when: -sale is made, service provided or transfer of ownership from seller to buyer -high probability of payment -if cash is received before goods or services are provided, the revenue can't be recognized until it is earned.

cash flow and valuation impact

-nonrecurring items with cash flow consequences do affect the value of the firm -their valuation implications differ from recurring items -requires careful attention to footnote disclosures Examples: -asset write downs (no cash flow impact) -employee severance costs (current period cash flow only) -lease payments for closed facilities (effects future cash flows)

Gross vs. net reporting

-occurs when internet merchandising firms sell products that they purchase from a supplier (amazon, ebay) but never held in inventory. -if the firms can't meet these criteria it reports net revenue. Report gross revenue if the company is: -the primary contract obligator -bears inventory risk -bears credit risk and -can choose its supplier and can establish price

Percentage of completion on Income Statement

-provides a better measure of operating activity and trend in earning power -more informatie disclosure of the status of incomplete projects. -more aggressive accounting due to the earlier recognition of revenues and income. -more subjective because it involves cost estimates by management -Cash flow is the same under both methods.

Other issues of revenue recognition:

-revenue recognition methodology found in footnotes -firm may use various methods within the same firm -does the firm recognize revenue sooner or later? -how are cost estimates determined? -comparability within industry norms?

Installment sales

-sales proceeds are paid in installments over an extended period of time. -if there is significant doubt of the ability of the buyer to complete payment this method is used -conservate treatment since revenue recognition is deferred -under US GAAP full revenue is recognized in year of sale but some profit is deferred.

Dilutive securities

-securities that can be converted to common stock and that upon conversion or exercise "dilute" or reduce EPS. 1. convertible securities (preferred stock, bonds) 2. options 3. warrants 4. other rights of conversion (2-4, dilute EPS)

Antidilution

-securities whose inclusion in earnings per share computation would increase EPS (greater percentage change in EPS numerator than the increase in EPS in the denominator) -in computing diluted EPS we need to consider each security separately to determine if it is dilutive or antidilutive -any security that is antidilutive should be excluded from the EPS calculation and can NOT be used to offset dilutive securities.

potentially dilutive securities

-stock options -warrants -convertible debt -convertible preferred stock

WASO (weighted average number of shares)

-time weighted shares issued or purchased during the period of measurement affect the EPS reported. 1. share repurchases- are excluded from date of repurchase 2. share issues for cash or to acquire subsidiary- are included from date of issuance. 3. stock splits or stock dividends- represent receipt of additional shares by existing shareholder and the EPS calculation reflects the change from the beginning of the measurement period.

unusual OR infrequent items

-unusual in nature or infrequent in occurrence but NOT BOTH, the word "or" is very important. -reported as a single line item as part of income from continuing operations- above the line. -reported pre-tax above the line.

components of net income above "the line"

-unusual or infrequent items include items such as pretax gains or losses from the sale or impairment of assets or investments -analysts implication- should the item be included in forecasting future income? -read the footnotes to see the true measure of this recurring item.

Completed contract

-used for long term projects when there is no contract or no estimate of revenues or costs are unreliable or when the project outcome can't be reliably measured -used if percentage of completion conditions are not met. -revenues and expenses are not recognized until the entire project has been completed. -if a loss is expected on the contract, the loss is reported right away not upon project completion.

Cost recovery method

-used when costs to provide goods and services are not known, substantial uncertainty regarding collection. -no revenues are recognized until after all costs are incurred. -no profit is recognized until cash receipts exceed cost. -revenue is recognized after all cost are incurred -preferred method when costs are unknown Examples: -development of raw land. -recognition of franchise revenues when revenue is collectible but no reasonable estimate of collectibility.

Installment sales method

-used when the likelihood of collecting the sales proceeds is uncertain but the costs of the goods and services are known. -recognize gross profit, sales, and COGS in proportion to sales price. -results in delayed recognition of revenues/expenses and gross profit vs. sales method. -used with sales of non current assets and real estate.

Percentage of completion

-used with long term contracts where a contract exists and there are reliable estimates of revenues, costs and completion time or outcome can be measured reliably. -revenues and costs are recognized according to the proportion of work completed.

Revenue recognition for long term contracts

-when the production process extends beyond one accounting period (two different revenue recognition methods may be used) 1. percentage of completion method, more aggressive approach- revenue, expense and profits are recognized as the work is performed. 2. completed contract method, more conservative approach- revenue, expenses, and profit are not recognized until the contract is complete.

Expense recognition general principles

1. Accruals basis- matching principle -match costs against the associated revenues. Ex: inventories, depreciation, warranty expense, doubtful debt expense. 2. Period expenses -expenditures less directly matching the timings of revenues (administrative costs and depreciation expense).

Examples of other comprehensive income

1. Foreign currency translation adjustments (the effect of converting a foreign subsidiaries financial statements from foreign to domestic currency). 2. Minimum pension liability adjustment (adjustment of the pension liability to match corresponding periodic changes in the plan assets 3. unrealized gains or losses on cash flow hedging contracts. 4. unrealized holding gains and losses on available for sale securities.

Revenue recognition Methods

1. Sales Basis- most common 2. Percentage of completion- accounts for profits in stages 3. Completed contract- recognition of profit delayed until contract completion 4. installment sales- accounts for earnings in stages like percentage of completion. 5. cost recovery- similar to completed contact method. 6. Barter transactions

SEC criteria for revenue recognition (whether revenue is realized or realizable and earned)

1. There is evidence of an arrangement between the buyer and seller. 2. the product has been delivered or the service has been rendered. 3. the price is determined or determinable 4. the seller is reasonably sure of collecting money

Accounting changes: Change in accounting principle

1. change from one accounting method to another (lifo, fifo, poc) -retrospective application: IFRS and US GAAP require prior years data shown in the financial statement to be adjusted as if the newly adopted principle had been used. -financial statements within a report will all be consistent -reported directly in the current year's retained earnings.

2- FASB conditions for revenue recognition

1. completion of the earnings process -must provide all or virtually all of the goods or services for which it is to be paid AND must be possible to measure the total expected cost of the good or service. -seller must have no significant contingent obligation (warranty, upgrades- sale not complete if cost cannot be estimated). 2. assurance of payment -quantification of cash or assets expected to be received or reliable measurement of the proceeds to be received. -collectibility or realizability of proceeds after the sale is a critical issue.

Methods that can be used to measure proportion of work completed:

1. engineering estimate or physical milestone. 2. ratio of costs incurred to total estimated costs.

Analysts implications on expenses

1. expense estimates require management's insight and choice as to which method to use. -estimate for doubtful accounts -depreciation methodology and useful lives 2. deferral of expense recognition is an aggressive accounting technique. 3. located in footnotes. 4. consistent presentation year over year. 5. separate those prior year's items of income and expense that are likely to continue and those that won't continue for forecasting purposes (discontinued operations, extraordinary items).

unusual or infrequent examples

1. gains or losses from disposal of a portion of a business segment (plant shut down, severance) 2. gains or losses from sale of assets or investments in subsidiaries 3. impairments, write-offs, and restructuring costs 4. gains or losses from the early retirement of debt (note can be extraordinary if infrequent) 5. provisions against environmental remediation.

Measures of operating performance (operating profitability ratios)

1. gross profit margin 2. net profit margin

Convertible Debt (2 factors to consider)

1. if the convertible bonds were issued at a PREMIUM or at DISCOUNT, the interest expense must include the premium or the discount. (the amt of the interest expense add back to net income, net of tax, is the interest expense from the income statement NOT cash interest paid (coupon) shown on the SCF. The bond conversion rate (number of common shares per bond) may change over the life of the bond. For the dilutive EPS calculation use the most advantageous conversion rate available for the bond holder. (if the convertible bond was issued in 2002 w/ a conversion rate of 10 common share for each convertible bond but in2008 the conversion rate is 20 common shares per bond, use the 20 common share rate in the computation of dilutive EPS in any year of the calculation)

components of net income

1. items that directly relate to manufacture and sale of goods. 2. indirect costs. 3. operating income from continuing operations 4. recurring "other" income/revenue, interest or dividends from investments.

Accounting changes: change in accounting estimate

1. results from a managements change in judgement, based on new information. -doesn't require restatement of prior period earning. -handled prospectively -disclosed in footnotes -changes do not affect cash flow.

IASB requirements for revenue recognition (5 general principals)

1. risk and reward of ownership transferred 2. no continuing control or management involvement over the good sold 3. amount of revenue is reliable 4. probable flow of economic benefits to the firm 5. cost incurred can be reliably measured

Percentage of Completion

Advantage: better matching of revenue with the accounting period it is earned. Disadvantage: may overstate revenue and gross profit if expenditures made are recognized BEFORE they contribute to the completed work. ex: when costs of raw material or advance payments to subcontractors are included in the determination of work completed.

anti-dilutive securities

Are securities that upon conversion or exercise INCREASE EPS (as opposed to decrease with dilutive effects.

Revenue recognition in special cases (BEFORE, AT TIME, AND AFTER GOODS DELIVIERED)

BEFORE goods are delivered: percentage of completion if costs can be reliably measured. AT THE TIME goods are delivered: normal framework criteria. AFTER goods are delivered: installment and cost recover method (real estate transactions)

Inventory methods

FIFO: Ending inventory most recent purchases, EI= highest, COGS= lowest. LIFO: EI oldest purchases, EI- lowest, COGS= highest, prohibited under IFRS AVCO: average cost of units available, EI= middle, COGS= middle.

income statement (gross profit, operating profit(EBIT), and net income/profit)

Gross profit: the amount that remains once the cost of a product or service is subtracted from net revenue. Operating Profit (EBIT): is the amount that remains BEFORE financing costs and income taxes are considered. Net income/profit: is the amount of operating profit AFTER interest expense and income taxes.

Expense recognition

IASB: "expenses decrease economic benefits in the form of outflows or depletion of assets or incurrence of liability that result in a decrease in equity.

the effects of convertible securities

IF CONVERTIBLE PREFERRED STOCK is dilutive (meaning EPS will fall if stock is converted), the convertible preferred dividends must be added back to the previously calculated earnings avail. to the common shareholders. IF CONVERTIBLE BONDS are dilutive: then the bonds after-tax interest expense would not be considered as an interest expense for diluted EPS.

Income statement (what investors and lenders do)

Investors: examine a firms income statement for valuation purposes while... lenders: examine the incomes statement for information about the firm's ultimate ability to repay debt.

What does the discontinuation or sale of a business indicate?

May indicate that: -inadequate or uncertain markets -unsatisfactory contribution to earnings -no longer a strategic fit by management -can be sold at a significant gain (because they no longer provide earnings, the analyst can eliminate that item from future expectations on company performance).

Income Statement sections

OPERATING INCOME: -sales or revenue -cost of goods sold -selling expenses -administratvie expenses NON-OPERATING INCOME: -income tax -discontinued operations -extraordinary items -earnings per share

Simple vs. complex capital structures

Simple capital structure: contains no potentially dilutive securities (firm reports only basic EPS) complex capital structure: contains potentially dilutive securities (firm reports both basic and diluted EPS)

Accrual Accounting, revenue and expense recognition

Two primary issues: -Timing: when should the transaction be recognized -measurement: how much of the transaction should be recognized -management has considerable latitude in making these decisions

Dilutive vs. antidilutive securities

dilutive securities: decrease EPS if exercised or converted to common stock. antidilutive securities: increase EPS if exercised or converted to common stock.

problem with basic EPS-

fails to consider the potentially dilutive impact on outstanding stock when a firm has dilutive securities.

Earnings per share (EPS)

is "income earned by each share of common stock". -preferred dividends are subtracted from net income -common stock dividends are not subtracted from net income.

Discontinued operations

operating income and any gains or losses from the sale of a subsidiary, business line or segment are reported separatley as discontinued operations, since these activities will not contribute to future income and cash flows. -requires measurement date- MGT. formal plan -presented after tax (BELOW THE LINE)