Chapter 4: Income Statement, Comprehensive Income, and the Statement of Cash Flows Intermediate Accounting 1

Operating income should include

"reproducible" results No guarantees, but revenues and expenses are more likely to recur more than one-time gains/losses from sales of investments. Generally, items that are higher on the income statement have higher earnings quality than things lower on the income statement (exceptions: Interest, taxes)

Accounting changes fall into one of three categories:

(1) a change in an accounting principle, (2) a change in estimate, or (3) a change in reporting entity.

U.S. GAAP requires that public companies report two specific calculations of EPS:

(1) basic EPS and (2) diluted EPS

SCF classifies all transactions affecting cash into one of three categories:

(1) operating activities, (2) investing activities, and (3) financing activities.

Resources should be allocated to private enterprises that will

(1) provide the goods and services our society desires and (2) at the same time provide a fair rate of return to those who supply the resources.

The 3 major components of income from continuing operations include:

1. Operating income 2. Nonoperating income 3. Income tax expense

Cash outflows from investing activities include cash paid for the following:

1. The purchase of long-lived assets used in the business. 2. The purchase of investment securities like stocks and bonds of other entities (other than those classified as cash equivalents and trading securities). 3. Loans to other entities.

Cash inflows from these transactions are considered investing activities:

1. The sale of long-lived assets used in the business. 2. The sale of investment securities (other than cash equivalents and trading securities). 3. The collection of a nontrade receivable (excluding the collection of interest, which is an operating activity).

Average days in inventory =

365 / inventory turnover ratio

Average collection period =

365 / receivables turnover ratio

Investing section

All cash paid/received for intermediate/long-term assets This includes *ALL* gains/losses related to these assets *these are reversed out of net income when using the indirect method and omitted from operations in the direct method so they are not "double counted")

Financing section

All cash paid/received related to debt/equity financing This includes repayment of long-term loans (bonds) and the payment of dividends. Interest payments are excluded from this section and are included in the operating section.

Single-step income statement

An income statement format that first lists all the revenues and gains included in income from continuing operations. Then, expenses and losses are grouped, subtotaled, and subtracted- in a single step- from revenues and gains to derive income from continuing operations. In a departure from that, though, companies usually report income tax expenses in a separate line in the statement. In a single-step income statement, operating and nonoperating items are not separately classified.

Purpose of cash flows

Assess company's ability to generate positive future cash flows. -cash flow is the life blood of a business. -Net income *DOES NOT* equal cash flow Assess effect of investing and financing decisions on cash flows -Where did the money come from (if not from operations)? -Where did the money go? Expressing all transactions in terms of changes to cash (A= L + E)

Indirect method

Cash flow from operating activities is derived indirectly by starting with reported net income and adding or subtracting items to convert that amount to a cash basis. 2 adjustments to net income are needed when using this method: 1. Components of net income that do not affect operating cash are reversed 2. Net income is adjusted for changes in operating assets and liabilities during the period. From class notes: Adjust net income to cash basis. Since we are adjusting net income to cash basis income, net income is *ALWAYS* the starting point for this method. We adjust net income to reverse the effects of accrual basis accounting.

Reporting discontinued operations

Component must be shown separately for all years shown. If the component has been sold: -Income/loss from beginning of period to date of disposal. -Plus/minus gain/loss on disposal(s) -Plus/minus intraperiod tax allocation (expense/benefits) If the component is still held for sale: -Income/loss from entire period (since still held) -Less impairment losses (if any) -Plus/minus intraperiod tax allocation (expense/benefits) On the balance sheet: Assets/Liabilities are reported separately, not as a net asset or net liability.

Losses

Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from expenses or distributions to owners.

Bottom of income statement

EBIT - Interest expense = EBT (Earnings before taxes) EBT - Tax expense = Income from continuing operations

Taxes are not good indicators of

Earnings quality because they can change year to year.

Basic EPS

Equals total net income (less any dividends to preferred shareholders) divided by the weighted-average number of common shares outstanding.

Return on assets (ROA)

Expresses income as a percentage of the average total assets available to generate that income. Because total assets are partially financed with debt and partially by equity funds, this is an inclusive way of measuring earning power that ignores specific sources of financing.

Earnings per share (EPS)

For individual decision-making, investors want to know how much profit has been generated for each shareholder. We calculate earnings per share to relate the amount of net income a company generates to the number of common shares outstanding.

Nonoperating items

Gains and losses from the sale of investments typically relate only tangentially to normal operations.

Cash equivalents

Includes highly liquid (easily converted to cash) investments such as treasury bills.

Operating income

Includes revenues, expenses, gains, and losses directly related to the primary revenue-generating activities of a company. For a manufacturing company, operating income includes sales revenue from selling the products it manufacturer minus the cost of goods sold and operating expenses related to its *primary activities*.

Nonoperating income

Includes revenues, expenses, gains, and losses related to peripheral or incidental activities of the company. For example, a manufacturer would include interest revenue, gains and losses from selling investments, and interest expense in non-operating income. These items are not directly related to the primary revenue-generating activities of a manufacturing company. *Peripheral or incidental activities*

Two financial statements that are critical for understanding the company's ability to earn profits and generate cash in the future are as follows:

Income statement (also called statement of operations or statement of earnings) Statement of cash flows

Diluted EPS

Incorporates the dilutive effect of all potential common shares in the calculation of EPS. Dilution refers to the reduction in EPS that occurs as the number of common shares outstanding increases.

Gains

Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owners.

Transitory earnings

Non-recurring and/or incidental/ancillary items

Permanent earnings

Normally recurring, operating items

Single-step

Operating income determined in one step Revenues/recurring gains minus expenses/recurring losses = EBIT (Earnings before interest and taxes) Format is the same as the multi-step after the EBIT subtotal

Change in accounting principle

Refers to a change from one acceptable accounting method to another.

Earnings quality

Refers to the ability of reported earnings (income) to predict a company's future earnings. EX: service revenue has a high earnings quality because it can estimate next year's earnings. (and is at the top of the income statement)

Tax expense

Reported on its own line on the Income statement. Can be allocated between continuing (operating) and discontinued (nonoperating) activities

Income statement

Reports a company's profit during a particular reporting period. Measures over a period of time.

Multiple-step format income statement

Reports a series of intermediate subtotals such as gross profit, operating income, and income before taxes. Most of the real-world income statements are in this format.

DuPont framework equation

Return on equity = Profit margin x Asset turnover x Equity multiplier Or Net income / average total equity = net income/net sales x net sales/average total assets x average total assets/average total equity

The balance sheet is affected too when a component is considered held for sale.

The assets and liabilities of the component considered held for sale are reported at the lower of their book value or fair value minus cost to sell. And, because it's not in use, an asset classified as held for sale is no longer reported as part of property, plant, and equipment, or intangible assets and is not depreciated or amortized.

Direct method

The cash effect of each operating activity is reported directly in the SCF. For example, cash received from customers is reported as the cash effect of sales activities. Income statement transactions that have no cash flow effect, such as depreciation, are simply not reported. From class notes: Adjust each Income statement account to cash basis. This method looks at each individual account on the income statements and directly adjusts each account from accrual to cash basis. -Ignore non-cash accounts and subtotals. -Cash collections (positive cash flows) -Cash payments (negative cash flows) -Adjust cash-related Income statement accounts (line-by-line) from accrual to cash based on changes to related assets/liabilities account balances.

Retrospective approach

The new standard is applied to all periods presented in the financial statements. That is, we restate prior period financial statements as if the new accounting method had been used in those prior periods. We revise the balance of each account affected to make those statements appear as if the newly adopted accounting method had been applied all along.

Income from continuing operations

The result of the business's normally recurring activities. Income from continuing operations +/- inc/loss from discontinued operations (if any) = net income If no discontinued operations, then income from continued operations = net income EPS information added after Net Income

Comprehensive income

The total change in equity for a reporting period other than from transactions with owners.

Prospective approach

This approach requires neither a modification of prior period financial statements nor an adjustment to account balances. Instead, the change is simply implemented in the current period and all future periods.

Investing activities include inflows and outflows of cash related to the

acquisition and disposition of long-lived assets used in the operations of the business (such as property, plant, and equipment) and investment assets (except those classified as cash equivalents and trading securities). The purchase and sale of inventory are not considered investing activities (it is included in operating activities).

Expenses are reported when incurred, not necessarily when cash is

actually paid for those expenses.

When calculating profitability ratios, analysts often adjust net income for

any temporary income effects.

The Sarbanes-Oxley Act requires reconciliation

between non-GAAP earnings and earnings determined according to GAAP.

Changes in assets and liabilities can indicate that

cash inflows are different from revenues and cash outflows are different from expenses.

Changes in depreciation, amortization or depletion methods are accounted for the same way as a

change in an accounting estimate. Requires a clear justification as to why the new method is preferable.

Activity ratios measure a

company's efficiency in managing its assets

Net income and comprehensive income are identical for an enterprise that has no other

comprehensive income items. When this occurs for all years presented, a statement of comprehensive income is not required.

The revenues, expenses, gains, and losses, and income tax related to a discontinued operation must be removed from

continuing operations and reported separately for all years presented.

Classification shifting inflates

core performance

Net cash flows from financing activities equal the

difference between the inflows and outflows.

Net cash flows from investing activities equal the

difference between the inflows and outflows.

All corporations whose common stock is publicly traded must

disclose EPS

The difference between the single-step and multiple-step income statement is

due to the presentation. The bottom line, net income, is the same regardless of the format used.

When recognizing expenses we attempt to establish a causal relationship between revenues and expenses. If causality can be determined,

expenses are reported in the same period that the related revenue is recognized. If a causal relationship cannot be established, we relate the expense to a particular period, allocate it over several periods, or expense it as incurred.

Ratio analysis does not explain what is wrong. It does provide information that

highlights areas for further investigation.

In case there is a loss from discontinued operations, there would be an

income tax benefit (instead of income tax expense); losses from discontinued operations are tax-deductible and would reduce overall taxes owed, thereby providing a benefit

Discontinued operations and unusual items are reported entirely within the

intermin period in which they occur.

Unusual items included in operating income require

investigation to determine their permanent or temporary nature.

Depreciation expense is not included as cash outflows from operating activities because

it doesn't affect cash at all.

For accounting information to be useful to decision-makers,

it must be available on a timely basis.

The difference between inflows and outflows is called

net flows from operating activities. This is equivalent to net income if the income statement had been prepared on a cash basis rather than an accrual basis.

Return on equity =

net income / average shareholders' equity or Return on assets x equity multiplier or Net income/average total equity = net income/average total assets x average total assets/average total equity

Return on assets =

net income / average total assets or Profit margin x asset turnover (Net income / average total assets = net income/net sales x net sales/average total assets)

Profit margin on sales =

net income / net sales

FASB has established no conceptual basis for determining which gains and losses qualify for

net income versus other comprehensive income. To help avoid confusion about which amounts are included in net income versus other comprehensive income, companies are required to provide a reconciliation from net income to comprehensive income.

Intermin reports are issued for periods

of less than a year, typically as quarterly financial statements.

Occasionally, without being required by the FASB, a company will change from

one generally accepted accounting principle to another. For example, a company may decide to change its inventory method from LIFO to FIFO. When this occurs, inventory and cost of goods sold are measured in one reporting period using LIFO, but then are measured using FIFO in a subsequent period.

The payment of interest to a creditor is classified as an

operating activity

A few types of gains and losses are excluded from the income statement but are included in the broader concept of comprehensive income. We refer to these other gains and losses as

other comprehensive income (OCI)

Income smoothing may help investors to

predict future performance but it could also hide underlying risk.

Two generally accepted formats can be used to

report operating activities, the direct method and the indirect method.

The cumulative total of OCI (or comprehensive loss) is

reported as accumulated other comprehensive income (AOCI), an additional component of shareholders' equity that is displayed separately.

Income from discontinued operations (and its tax effect) are

reported separately

Gains and losses deal with

secondary transactions ex: A car company selling land (their real job isn't selling land)

Income tax expense is reported in a

separate line in the income statement.

Restructuring costs include costs associated with

shutdown or relocation of facilities or downsizing of operations. GAAP requires that restructuring costs be recognized only in the period incurred.

Reporting comprehensive income can be accomplished with a

single, continuous statement or in two separate, but consecutive statements.

If the direct method is used,

the business *MUST* reconcile net income to operating cash flows (indirect method).

The term cash in the statement of cash flows refers to the

total of cash, cash equivalents, and restricted cash.

Changes in shareholders' equity arise from two sources

transactions with owners (shareholders) and transactions with nonowners. Transactions with owners include events such as increasing equity by issuing stock to shareholders or decreasing equity by purchasing stock from shareholders and paying dividends.

By the indirect method, we start with net income and

work backward to convert that amount to a cash basis.

Complete financial statements are not required for intermin period reporting, but certain minimum disclosures are required as follows:

-Sales, income taxes, and net income -Earnings per share -Seasonal revenues, costs, and expenses -Significant changes in estimates for income taxes -Discontinued operations and unusual items -Contingencies -Changes in accounting principles or estimates -Information about fair value of financial instruments and the methods and assumptions used to estimate fair values -Significant changes in financial position

Discontinued operations are reported when

1. A component of an entity or group of companies has been sold or disposed of or is considered held for sale. The component of an entity includes activities and cash flows that can be clearly distinguished, operationally, and for financial reporting purposes, from the rest of the company. A component could include an operating segment, a reporting unit, a subsidiary, or an asset group. 2. If the disposal represents a strategic shift that has, or will have, a major effect on a company's operations and financial results. Examples of possible strategic shifts include the disposal of operations in a major geographical area, a major line of business, a major equity method investment, or other major parts of the company.

Cash inflows include cash received from the following:

1. Customers from the sale of goods or services. 2. Interest and dividends from investments

Five Rules for Adjusting Net Income Using the Indirect Method

1. Each change to a current asset is an opposite adjustment to Net Income. 2. Each change to a current liability is the same adjustment to Net Income. 3. Add back to non-cash expenses (e.g., depreciation, amortization, depletion) 4. Eliminate all gains/losses by using their opposite adjustment. 5. Eliminate amortization of bond premium (-) or disc (+) ---> opposite adjustment

When the discontinued component is sold before the end of the reporting period, the reported income effects of a discontinued operation will include two elements:

1. Income or Loss from operations (revenues, expenses, gains, and losses) of the component from the beginning of the reporting period to the disposal date. 2. Gain or loss on disposal of the component's assets.

When the component is considered held for sale:

1. Income or loss from operations (revenues, expenses, gains, and losses) of the component from the beginning of the reporting period to the end of the reporting period. 2. An impairment loss if the book value (sometimes called carrying value or carrying amount) of the assets of the component is more than fair value minus cost to sell.

Financing cash outflows include cash paid to the following:

1. Owners in the form of dividends or other distributions. 2. Owners for the reacquisition of shares previously sold. 3. Creditors as repayment of the principal amounts of debt (excluding trade payables that relate to operating activities).

Financing cash inflows include cash received from the following:

1. Owners when shares are sold to them. 2. Creditors when cash is borrowed through notes, loans, mortgages, and bonds.

Cash outflows include cash paid for the following:

1. The purchase of inventory 2. Salaries, wages, and other operating expenses 3. Interest on debt 4. Income taxes

Two Rules for Adjusting via the Direct Method

Assets = adjustment opposite direction (e.g., deduct increases) Liabilities = adjustment same direction (e.g., deduct decreases)

Profitability ratios

Assist in evaluating various aspects of a company's profit-making activities.

Average collection period

Indicates the average age of accounts receivable. This measure is computed by dividing 365 days by the receivables turnover ratio. The result is an approximation of the number of days the average accounts receivable balance is outstanding.

Revenues

Inflow or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations.

Operating activities

Inflows and outflows of cash related to the transactions entering into the determination of net operating income.

Schedule of Non-cash Investing and Financing Transactions

Lists all non-ash investing and financing transactions No prescribed format Includes listing partial transactions: Ex. Building purchase ~20% down payment --> cash transaction reported in the investing section. ~80% loan --> noncash transaction (loan for building) -A building purchase would normally be reported completely in the investing section. -Debt issuance would normally be reported completely in the financing section. -Therefore, this part of the transaction (80% loan) is reported in the Schedule of Noncash Investing and Financing Transactions

Non-GAAP earnings

Many companies voluntarily provide non-GAAP earnings management's assessment of permanent earnings. Non-GAAP earnings exclude certain expenses and certain revenues. Common expenses excluded are restructuring costs, acquisition costs, write-down of impaired assets, and stock-based compensation.

Inventory turnover ratio

Measures a company's efficiency in managing its investment in inventory. The ratio shows the number of times the average inventory balance is sold during a reporting period. It indicates how quickly inventory is sold. The ratio is computed by dividing the period's cost of goods sold by the average inventory balance. The denominator, average inventory, is determined by adding the beginning and ending inventory and dividing by 2. A high inventory turnover ratio indicates comparative strength, perhaps caused by a company's superior sales force or maybe a successful advertising campaign.

Asset turnover ratio

Measures a company's efficiency in using assets to generate revenue. Average assets are determined by adding the beginning and ending total assets and dividing them by zero.

Profit margin on sales

Measures the amount of net income achieved per sales dollar. Simply net income divided by net sales. Indicates the portion of each dollar of revenue that is available after all expenses have been covered. It offers a measure of the company's ability to withstand either higher expenses or lower revenues.

Return on equity

Measures the return to suppliers of equity capital. Calculated as net income divided by average shareholders' equity.

Comprehensive income =

Net income + other comprehensive income

Receivables turnover ratio =

Net sales / average accounts receivable (net)

Asset turnover ratio =

Net sales / average total assets

Receivables turnover ratio

Offers an indication of how quickly a company is able to collect its accounts receivables. Calculated by dividing a period's net credit sales by the average net accounts receivable. Average accounts receivable is determined by adding the beginning and ending net accounts receivable (gross accounts receivable less allowance for uncollectible accounts) and dividing by 2. The higher the ratio, the shorter the average time between sales and cash collection.

Expenses

Outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations.

Component

Part of a business for which cash flows and operations can be separated from the rest of the entity. Reportable when: -Disposal meets the definition of a component (otherwise, report disposal w/ operating results) -Disposal represents a strategic shift

Statement of cash flows

Provides information about the cash receipts and cash payments of a company during a particular reporting period. To help investors and creditors better understand the sources and uses of cash during the period, the statement of cash flows distinguishes among operating, investing, and financing activities. Presented for each period for which an income statement is provided. The purpose of the SCF is to provide information about the cash receipts and cash disbursements of an enterprise. Similar to the income statement, the SCF is a change statement, summarizing the transactions that affected cash during the period.

Discontinued operations

Purpose is to report the financial effect(s) of the disposal of a "component" separately from continuing operations. Companies sometimes decide to sell or dispose of a component of their business. The operations of that business component are known as discontinued operations. Because discontinued operations represent a material component of the company, the results from discontinued operations are reported separately in the income statement to allow financial statement users to more clearly understand results from continuing operations.

Disclosures in an Annual Report

Purpose: Provide all relevant information about the reporting entity. Typical notes: -Summary of significant accounting policies (usually note 1) -Subsequent events -Additional info about summary totals (most common note) Other parts of the Annual Report: -Management discussion and analysis -Management responsibilities -Directors/Top Executives Compensation -Auditor's Report (Opinion that financial statements are "presented fairly...in conformity with U.S. GAAP" and content of auditor's report such as opinion and basis for opinion)

Financing activities

Relates to the external financing of the company. Involve cash inflows and outflows from transactions with creditors (excluding trade payables) and owners.

Multiple-step income subtotals

Sales - COGS = Gross profit GP - SG&A exp = Operating income Operating income + Other Rev/Gain - Other Exp/Loss = EBIT Format is the same as the single-step after the EBIT subtotal

DuPont framework

Shows that return on equity depends on profitability, activity, and financial leverage. Provides a convenient basis for analysis that breaks return on equity into three components: 1. Profitability, measured by the profit margin (Net income / sales). A higher profit margin indicates that a company generates more profit from each dollar of sales. 2. Activity, measured by asset turnover (Sales / average total assets). Higher asset turnover indicates that a company uses its assets efficiently to generate more sales from each dollar of assets. 3. Financial Leverage, measured by the equity multiplier (Average total assets / average total equity). A high equity multiplier indicates that relatively more of the company's assets have been financed with debt; that is, the company is more leveraged. Leverage can provide additional return to the company's equity holders.

Modified retrospective approach

The new standard is applied to the adoption period only. Prior period financial statements are not restated. The cumulative effect of the change on prior periods' net income is shown as an adjustment to the beginning balance of retained earnings in the adoption period.

The difference between cash receipts and cash payments represents the

change in cash for the period.

The vast majority of errors are not material and are, therefore, simply

corrected in the year discovered.

Inventory turnover ratio =

cost of goods sold / average inventory

A change in accounting estimate is reflected in the financial statements of the

current period and future periods. When an estimate is modified as new information comes to light, accounting for the change in estimate is quite straightforward. We do not revise prior years' financial statements to reflect the new estimate. Instead, we merely incorporate the new estimate in any related accounting determinations from that point on; that is, we account for a change in accounting estimates prospectively. If the effect of the change is material, a disclosure note is needed to describe the change and its effect on both net income and earnings per share.

There are a few gains and losses that are not reported in the income statement but nevertheless affect

equity. These other gains and losses are reported as other comprehensive income (OCI).

When tax rules and GAAP differ regarding the timing of revenue or expense recognition, the actual payment of taxes may occur in a

period different from when income tax expense is reported in the income statement.

Gains and losses are increases or decreases in equity from

peripheral or incidental transactions of an entity. In general, these gains and losses do not reflect normal operating activities of the company, but they nevertheless represent transactions that affect a company's financial position.

Revenues and expenses deal with

primary transactions ex: A car company producing cars

A primary advantage of the multiple-step format is that, by separately classifying operating and nonoperating items, it

provides information that might be useful in analyzing trends.

Profit margin and asset turnover combine to yield a

return on assets, which measures the return generated by a company's assets.

Profit =

revenues and gains minus expenses and losses

Income from continuing operations includes the

revenues, expenses, gains, and losses from operations that are more likely to continue into the future.

If a component to be discontinued has not yet been sold, its income effects, including any impairment loss, are usually

still are reported separately as discontinued operations.

Depreciation expense does not reduce cash but is

subtracted in the income statement. So, we add back depreciation expense to net income to eliminate it.

Average days in inventory indicate the number of days it normally

takes to sell inventory.

Income taxes are levied on taxpayers in proportion to the amount of

taxable income that is reported to taxing authorities. Like individuals, corporations are income-tax-paying entities. Because of the importance and size of income tax expense (sometimes called provision for income taxes), it always is reported in a separate line in corporate income statements.