Sammy Skateboard Results: 20 mean (25 points) Quiz # 1 Results: 11.6 mean (17 points) Project 1...

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

AnnouncementsAnnouncements

The income statement lists the following for a firm over a period of time:

RevenuesExpensesGains 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.

The Income StatementThe Income Statement

Evaluate past performance of a companyFeedback value

Provide a basis for predicting future performance

Predictive value

Assist in assessing the risk or uncertainty of future cash flows

Predictive value

Usefulness of the Income Statement

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.

Limitations of the Income Statement

Managers timing reporting of revenues, expenses, gains and losses to meet their incentivesGenerally used to increase income in the current year at the expense of income in future yearsCan also be used to decrease income in current year in order to increase income in future periods

The Income Statement – The Income Statement – Earnings ManagementEarnings Management

Examples:

AOL Time Warner

Bristol-Myers Squibb

Enron

Worldcom

Xerox

The Income Statement – The Income Statement – Earnings ManagementEarnings Management

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

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

Income Statement Income Statement PresentationPresentation

The single-step statement consists of just two groupings:

I ncome Statement (in thousands)

Revenues:

Sales 285,000$ I nterest revenue 17,000

Total revenue 302,000 Expenses:

Cost of goods sold 149,000 Advertising expense 10,000 Depreciation expense 43,000 I nterest expense 21,000 I ncome tax expense 24,000

Total expenses 247,000 Net income 55,000$

Earnings per share 0.75$

Revenues

Expenses

Net Income

Single- Single- StepStep

Single- Single- StepStep

No distinction between Operating and Non-operating categories.

Single-Step Income Single-Step Income StatementStatement

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.


The presentation divides information into major sections.

The presentation divides information into major sections.


Sales 285,000$

Cost of goods sold 149,000 Gross profi t 136,000

Operating expenses:

Advertising expense 10,000 Depreciation expense 43,000

Total operating expense 53,000 I ncome from operations 83,000

Other revenue (expense):

I nterest revenue 17,000 I nterest expense (21,000)

Total other (4,000) I ncome bef ore taxes 79,000 I ncome tax expense 24,000 Net income 55,000$

Earnings per share 0.75$

1. Operating Section

1. Operating Section

2. Nonoperating Section

2. Nonoperating Section

3. Income tax 3. Income tax

Multi-Step Income Multi-Step Income StatementStatement

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.


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.


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


Discontinued Operations

Basic criteria (see SFAS144 for more detail):

1. The results of operations and cash flows of a component of a company have been (or will be) eliminated from ongoing operations.

2. No significant continuing involvement in that component after disposal transaction.

Reporting Irregular Reporting Irregular ItemsItems

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

Reporting Discontinued Reporting Discontinued OperationsOperations

Time Line for Discontinued Operations

Measurement Date

Year-end Final Disposal

Loss from Operations

(B)

Year-end

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

Example: Albertson’s (2003)

January 30, 2003 January 31, 2002Earnings from continuing operations before taxes 1,405 863Income tax expense 540 367--------------------------------------- ----------------- -----------Earnings from continuing operations 865 496 Discontinued operations:Operating (loss) income (50) 10 Loss on disposition (379) - Tax (benefit) expense (143) 5 ------------------------------------- ----------------- -----------Net (loss) earnings from discontinued operations (286) 5

Discontinued Operations

Presentation:

1. 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.

2. 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”).


Extraordinary Items

Item must meet BOTH of the following criteria:

1. 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.

2. 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”).


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.


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.


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?


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.


Categories of Accounting Changes:

1. Change in Accounting Principle

2. Change in Accounting Estimate

3. Errors in Financial Statements

Accounting ChangesAccounting Changes

1. Currently. Report cumulative effect of the change in the current period on current year income statement.

2. 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.

3. Prospectively. No change is made to previously reported results. No cumulative adjustment. Apply new principle on in current and future periods.

Accounting Changes – Accounting Changes – 3 possible approaches to 3 possible approaches to

applyapply

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.


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).


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.


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”.


Examples:Change from an accounting principle that is not GAAP.Mathematical mistakesChanges 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.

Correction of ErrorsCorrection 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.

Correction of ErrorsCorrection of Errors

• Tax expense for year related to specific items.

• Used for:– Income from continuing operations– Discontinued operations– Extraordinary items

Intra-period Tax Intra-period Tax AllocationAllocation

I nterest expense (21,000) Total other (4,000)

I ncome bef ore taxes 79,000 I ncome tax expense 24,000 I ncome from continuing operations 55,000

Discontinued operations:

Loss from operations, net of tax 315

Loss on disposal, net of tax 189

Total loss on discontinued operations 504

I ncome before extraordinary item 54,496

Extraordinary loss, net of tax 539

Net income 53,957$


Sales 285,000$

Cost of goods sold 149,000

Reporting when both Discontinued

Operations and Extraordinary Items

are present.

Discontinued OperationsDiscontinued Operations

Extraordinary ItemExtraordinary Item

Irregular ItemsIrregular Items

• Basic EPS• Diluted EPS • Companies required to disclose

both Basic EPS and Diluted EPS

Earnings Per ShareEarnings Per Share

Earnings per share is:• Computed as:

Net Income less Preferred DividendsWeighted Average of Common Shares Outstanding

• Disclosed on the income statement for all the major sections.

Basic Earnings Per ShareBasic 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:

Basic Earnings Per ShareBasic 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 20,000,000

During 2007, Hertz Corporation did not issue any additional common stock. The following also occurred during 2007.

Income from continuing operations before taxes $23,650,000Discontinued operations (loss before taxes) $ 3,225,000Preferred dividends declared $ 1,075,000Effective tax rate 35%

Compute EPS as it should appear on the 2007 f/s.

Earnings Per ShareEarnings Per Share

• 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)

Retained Earnings Retained Earnings StatementStatement

• 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)

Comprehensive IncomeComprehensive 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)

Other Comprehensive Other Comprehensive IncomeIncome

A = L + OEOE = CC + RE + AOCIAOCIend = AOCIbeg + OCI

REbeg + NI – DIV = REend

OE = CC + REbeg + NI - DIV + AOCIbeg + OCI

Other Comprehensive Other Comprehensive IncomeIncome

Sammy Skateboard Results: 20 mean (25 points) Quiz # 1 Results: 11.6 mean (17 points) Project 1...

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