CHAPTERS

CHAPTERSCHAPTERS

1515 & &1818

FINANCIAL REPORTING:FINANCIAL REPORTING:

Part 1: The Income StatementPart 1: The Income Statement

INCOME STATEMENTSINCOME STATEMENTSAdditional SectionsAdditional 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 Expenses2. Discontinued operations3. 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.

• 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 STATEMENTSINCOME STATEMENTS1. Non Operating Revenues and Expenses1. Non Operating Revenues and Expenses

INCOME STATEMENTSINCOME STATEMENTS2. Discontinued Operations2. 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.

INCOME STATEMENTSINCOME STATEMENTS3. Extraordinary Items3. Extraordinary Items

• Extraordinary items are events and transactions that meet three conditions:

1. Infrequent

2. Non-typical

3. Not subject to management decision

INCOME STATEMENTS INCOME STATEMENTS Extraordinary vs. Non-ExtraordinaryExtraordinary 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

INCOME STATEMENTSINCOME STATEMENTSPresentation – From Operating Income OnwardsPresentation – From Operating Income Onwards

Non – Operating ItemsNon – Operating ItemsOther Revenues and Gains

Operating Income

Other Expenses and Losses

Casualty Loss from VandalismTotal 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 savingsIncome (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…

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 STATEMENTSINCOME STATEMENTSEarnings Per Share - Additional DisclosuresEarnings 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

Prior Period AdjustmentsPrior 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)

Prior Period AdjustmentsPrior 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

Do Problems:

P15-6A

P15-7A

EARNINGS PER SHAREEARNINGS 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

PRICE - EARNINGS RATIOPRICE - 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 sharePrice-Earnings

Ratio

FINANCIAL REPORTING:FINANCIAL REPORTING:

Part 2: The Statement of Changes Part 2: The Statement of Changes in Financial Position, or The Cash in Financial Position, or The Cash Flow Statement, or the Statement Flow Statement, or the Statement of Cash Flows, or that statement of Cash Flows, or that statement that Boulton never taught us way that Boulton never taught us way

back in grade 11 with eighteen back in grade 11 with eighteen versions of a really, really long versions of a really, really long damn name that I can’t even be damn name that I can’t even be

bothered to remember so I’ll just bothered to remember so I’ll just call it whatever comes into my call it whatever comes into my

head.head.

CHAPTERSCHAPTERS

1515 & &1818

CASH FLOW STATEMENTCASH FLOW STATEMENTPurposePurpose


• 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.”



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.)

CASH FLOW STATEMENTCASH FLOW STATEMENTWhat You NeedWhat 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

• Know that there are three sections to the Statement:

1. Operating activities

2. Investing activities

3. Financing activities



• 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 STATEMENTCASH FLOW STATEMENTThe ProcessThe Process


• 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.


• 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 STATEMENTCASH FLOW STATEMENTStep 2.Step 2.

CASH FLOW STATEMENTCASH FLOW STATEMENTStep 2.Step 2.

• Operating activities include:– Regular business operations, i.e. the cash effects of

transactions that create revenues and expenses• Generally:

CASH FLOW STATEMENTCASH FLOW STATEMENT Step 3: Operating Activities Step 3: Operating Activities

From the Balance Sheet From the Income StatementCurrent 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?

Why?

Example: Accounts Receivable

Example: Accounts Payable

• 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 STATEMENTCASH FLOW STATEMENTStep 3: Investing ActivitiesStep 3: Investing Activities

From the Balance SheetCapital 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.

• 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 STATEMENTCASH FLOW STATEMENTStep 3: Financing ActivitiesStep 3: Financing Activities

From the Balance SheetLong-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.

• 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 STATEMENTCASH FLOW STATEMENTStep 4: Additional InformationStep 4: Additional Information

CASH FLOW STATEMENTCASH FLOW STATEMENTWhat’s It Look Like?What’s It Look Like?

CASH FLOW STATEMENTCASH FLOW STATEMENTWhat’s It Look Like?What’s It Look Like?

COMPUTER SERVICES COMPANYCash Flow Statement — Indirect Method

For the Year Ended December 31, 2002Cash flows from operating activities

Net income 35,000$ Adjustments to reconcile net income to net cash

provided by operating activities:Increase in accounts receivable (30,000)$ Increase in inventory (25,000) Increase in accounts payable 15,000 Increase in accrued expenses payable 4,000 (36,000)

Net cash used by operating activities (1,000) Cash flows from investing activities

Purchase of equipment (10,000)$ Net cash used by investing activities (10,000)

Cash flows from financing activitiesIssue of common shares 60,000$ Payment of cash dividend (15,000)

Net cash provided by financing activities 45,000 Net increase in cash 34,000 Cash, January 1 - Cash, December 31 34,000$

• A Cash Flow Statement tells you many things

• You need to learn how to spot red flags and understand their significance

CASH FLOW STATEMENTCASH FLOW STATEMENTWhat’s It Mean?What’s It Mean?


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 STATEMENTCASH FLOW STATEMENTWhat’s It Mean? – The Operating SectionWhat’s It Mean? – The Operating Section

CASH FLOW STATEMENTCASH FLOW STATEMENTWhat’s It Mean? – The Operating SectionWhat’s It Mean? – The Operating Section

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 STATEMENTCASH FLOW STATEMENTWhat’s It Mean? – The Operating SectionWhat’s It Mean? – The Operating SectionCASH FLOW STATEMENTCASH FLOW STATEMENT

What’s It Mean? – The Operating SectionWhat’s It Mean? – The Operating Section

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 STATEMENTCASH FLOW STATEMENTWhat’s It Mean? – The Investing SectionWhat’s It Mean? – The Investing SectionCASH FLOW STATEMENTCASH FLOW STATEMENTWhat’s It Mean? – The Investing SectionWhat’s It Mean? – The Investing Section

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 STATEMENTCASH FLOW STATEMENTWhat’s It Mean? – The Financing SectionWhat’s It Mean? – The Financing SectionCASH FLOW STATEMENTCASH FLOW STATEMENT

What’s It Mean? – The Financing SectionWhat’s It Mean? – The Financing Section

• 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 CURRENT DEBT COVERAGECASH 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

CASH RETURN ON SALESCASH 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


Net Sales

Cash Return on Sales

CASH FLOW PER SHARECASH 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

CASH TOTAL DEBT COVERAGECASH 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


Average Total

Liabilities

Cash Total Debt

Coverage

CHAPTERS

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