CHAPTER

4
Reporting Financial Performance
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Reporting Financial Performance

Income Statement Usefulness Limitations Quality of earnings Format of the Income Statement Elements Single-step Multiple-step Intermediate components Nature versus function Condensed income statement Reporting Irregular Items Discontinued operations Extraordinary items Unusual gains and losses Changes in estimates Special Reporting Issues Intraperiod tax allocation Earnings per share Retained earnings Comprehensive income IFRS/Private GAAP Comparison Comparison Analysis Looking ahead

Chapter Overview
Fundamentals Single-step vs. Multi-step Expense: by function vs. by nature Elements Condensed or not Tax allocation: Intra-period allocation Earnings Per Share: where and how Irregular items Discontinued operation Extraordinary items Comprehensive Income Assessment of quality Usefulness, limitations, Quality of earnings Statement of Equity
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Section 1

Income Statement

Exercise 4-5 (p.194)

(a) Prepare multiple-step I/S; expense presented by function (b) Prepare single-step I/S; expense presented by nature (c) Which format do you prefer? Why?

 By nature

Presenting Expenses: Nature versus Function

Expenses are recorded in a way that happen naturally
e.g. purchase of materials, transportation costs, payroll, depreciation, utility costs, advertisement costs, etc.

By function

No need to group into functions (simpler) Expenses are grouped in bigger categories that facilitates performance evaluation Typically four categories
Cost of goods sold Selling expenses Administrative expenses Interest expenses

Presenting Expenses: Nature versus Function

Under IFRS, analysis of expenses must be presented based on either:
Nature of expenses, or Function of expenses
If expenses are presented by function, nature of expenses must also be disclosed

No similar requirement under private entity GAAP Choice should result in information that is more reliable and relevant
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Single-Step Income Statement

(Assuming No Irregular Items)
Revenues Net Sales Other Revenues (e.g. Dividend, Rental) Expenses
Cost of Goods Sold Selling Expenses Administrative Expenses Interest Expense Income Tax Expense

Revenues

Expenses
List separately here

=
Net Income
Earnings per Share

Single-Step Income Statement (Assuming No Irregular Items)

Presents only two groupings before Income before Discontinued Operations: 1. Revenues (includes gains) 2. Expenses (includes losses) Income tax expense often reported separate from expenses as the last line item in determining net income Advantages: Simplicity Eliminates classification problems for revenues and expenses Disadvantage: Operating and non-operating activities reported together lower relevance

Multiple-Step Income Statement (Assuming No Irregular Items)

Operating Section
Net Sales Cost of Goods Sold Selling Expenses Administrative or General Expenses

Non-operating Section Unusual Gains/Losses (if any) Income Tax Net Income Earnings per share

Other Revenues and Gains Other Expenses and Losses

Atypical and Material, subject to mgr intention

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Unusual Gains and Losses

Gains and losses that do not qualify as an Extraordinary Item but are material in amount
One of Infrequent or Atypical AND does depend on Management decisions

Examples include
Write down of inventory; change in accounting estimates, gain or loss from sale of PP&E, etc.

Presentation on the income statement

Generally within income from continuous operation. If material, present as a separate item after operating income. If immaterial, combined with other revenue and expense items
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Multiple-Step Income Statement (Assuming No Irregular Items)

Operating and non-operating activities are separated Advantages:

Highlighting regular and irregular activities allows for greater predictive value (assess future earnings) and feedback value (assess past earnings) Provides better detail to compare companies Allows for ratio analysis used to assess performance
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What If There Exist Irregular Items?

Examples of irregular items
Discontinued operation Extraordinary gains/losses

These items must be reported separately in the Income Statement

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Reporting Irregular Items in I/S

1) Income from continuing operations 2) Discontinued Operations: Single-step based or multiple-step based
Income/Loss from discontinued operations Gain/Loss from disposition Material gains/losses Infrequent Not subject to mgmt intention
Reported net of taxes Previously used in GAAP, not allowed in IFRS, not mentioned in PE GAAP

3) Extraordinary Items:
4) Net Income

5) Earnings per share

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Cautions
Note that single-step and multiple-step formats
Differ only in the preparation of income from continuing operations. Preparation of sections thereafter are in the same way. For both formats, without irregular items, income from continuing operations is indeed net income of the firm. Under IFRS, EPS should be presented for BOTH income from continuing operations AND net income The following sections should be reported NET OF TAX (i.e. intra-period tax allocation) 1. Income from continuing operations 2. Discontinued operations 3. Extraordinary items [not allowed under IFRS] 4. Other comprehensive income 15

Extraordinary Items
Three qualifying criteria:
Infrequent (non-recurring) and unusual (atypical business activities) Material in amount Not primarily dependent on management or owners decisions

All three of these must be met in order to qualify as an Extraordinary Item => Very rare in practice IFRS does not permit such category PE GAAP is silent on the issue
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Condensed Income Statement

Illustration 4-7 and 4-8 (p.167)

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Earnings per Share

IFRS require the following EPS information on I/S
EPS based on continuing operations EPS based on net income Basic EPS based on weighted average of common shares outstanding Diluted EPS (if any) based on the weighted average of common shares and potential additional shares

EPS based on discontinued operations may be disclosed in the notes to the financial statements PE GAAP has no such requirements One of the most important indicators; more in Chapter 17
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Discontinued Operations

Reporting Irregular ItemsDiscontinued Operations

Discontinued operations includes components that have been disposed of or are held for sale
i.e. Assets do not have to be actually disposed by reporting date to be classified into this section

The key is that the component generates its own cash flows and has its own distinct operations
PE GAAP and IFRS differ SIGNIFICANTLY!

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Reporting Irregular ItemsDiscontinued Operations

Under private entity GAAP - Components can include: an operating segment, reporting unit, subsidiary, asset group, or operations without assets Under IFRS: - Components can include: separate major line of business or geographical area of operations, or a business qualifying as held for sale upon acquisition Private entity GAAP less restrictive
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WA 4-3
WA 4-3 Anikan Limited has approved a formal plan to sell its head office tower to an outside party. A detailed plan has been approved by the board of directors. The building is on the books at $50 million (net book value). The estimated selling price is $49 million. The company will continue to use the building until the new head office is complete. Construction has not yet started on the new building, but the company has begun to look for a buyer. Discuss the following issues under PE GAAP and IFRS (a) Discuss if the building is qualified as discontinued operation (b) Discuss if the building is qualified as asset held for sale (c) Assume it is now two years later and construction of the new building is now complete. The company decided to sell the old building. The book value is now $45 million and the fair value is $42 million. Discuss if the building is qualified as asset held for sale. (d) What would be the presentation on the income statement and balance sheet?
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Discontinued Operations
ASSET HELD FOR SALE: Must satisfy certain criteria (p.155)

Authorized plan to sell Asset available for immediate sale in its current state Active search for a buyer Sale is probable within a year Asset is reasonably priced and actively marketed
Changes to the plan are unlikely.

Re-measured at the LOWER of

CARRYING VALUE and FAIR VALUE NET OF COST TO SELL

Once classified, no longer depreciate

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WA4-3 Solution
(a) PE GAAP: NO; IFRS: NO (b) PE GAAP: No; IFRS: NO (c) PE GAAP: Yes; IFRS: NO (d) Refer to the following two slides

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Discontinued Operations
Presentation on income statement
Presented separately from income from continuing operations Reported net of tax Presented with a distinction made between: - The components results of operations - Disposal of the components assets If asset held for sale is classified, it should be presented separately on balance sheet Under private entity GAAP, it retains original classification as current or non-current Under IFRS, it is generally classified as current asset
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Presentation on balance sheet

Discontinued Operations Statement Presentation (BE4-4)

Income from continuing operations (net of tax) $xx,xxx Discontinued Operations: Income (Loss) from operations (net of tax) $xx,xxx Gain (Loss) on disposal (net of tax) xx,xxx xx,xxx Net Income $xx,xxx

Earnings per share from continuing operations

Earnings per share from discontinued operations Earnings per share on net income

x
x

x
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Comprehensive Income

Theoretical Origin
Two approaches to calculate net income Transaction-based approach Net income is calculated based on income statement elements Net income = Revenues Expenses + Gains Losses Net income is transaction-based only All-inclusive approach (also called Capital maintenance approach) Net income is calculated based on balance sheet elements Net income = Ending OE Beginning OE (Owners Contributions - distributions to owners) Net income include both transaction-based and nontransaction based income 28

ILLUSTRATION (1)
Year 0 Assets $100 Liabilities 0 O/E $100 Year 1 Sales $100 CGS (40) Other Exp. (20) Tax (10) Net income $___ Transaction-based Income = Revenues- Expenses=$30 Assets Liabilities O/E Year 0 Year 1 $100 0 $100 $130 0 $130

Assume no owner activities (i.e. no contributions or distributions) in yr 1 => Net income=$_______

All inclusive income = OE owner activities = (130-100)-0=$30 Now assume the capital asset acquired in year 0 for $100 appreciated to $120, resulting unrealized holding gain of $20; Note the asset has not yet been disposed, hence the $20 gain is not transaction-based (i.e. not based on the disposal transaction).

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ILLUSTRATION (2)
Year 0 Assets $100 Liabilities 0 O/E $100 Year 1 Sales $100 CGS (40) Other Exp. (20) Tax (10) Net income $___ Transaction-based Income = Revenues- Expenses=$30 Assets Liabilities O/E Year 0 Year 1 $100 0 $100 $130 +20 0 $130 +20

Assume no owner activities (contribution, distribution) in yr 1 => Net income=$_______

All inclusive income = OE owner activities = (150-100) 0 = $50 Conclusion: when non-transaction-based income is recognized, the income calculated based on all-inclusive approach differs from that based on traditional transaction-based approach IFRS uses a modified all-inclusive approach.
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Comprehensive Income
Modified all-inclusive approach
Comprehensive income is based on all-inclusive approach Net income is based on transaction-based approach

Thus, comprehensive income includes

any item that causes a change in equity except for investments by owners, distributions to owners correction of errors and adjustments to retained earnings due to retrospective application of changes in accounting policy Example: unrealized gains/losses on revaluation of property, plant, and equipment under the revaluation model
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Comprehensive Income
Statement of comprehensive income can be presented
as a combined statement, combined with I/S (BE412) as a combined statement, combined with

Statement of Equity (slide #44) as a separate stand-alone statement Not required under PE GAAP

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Other Comprehensive Income (OCI)

Defined as Revenues, expenses, gains, and losses that are recognized in comprehensive income, but are not included in net income (e.g. unrealized holding gains and losses on certain securities) An innovative term created by standard setters to incorporate some non-traditional unrealized net income. Note although the information must be presented in the statements, IASB/FASB Exposure Draft does not require firms to use the term such as CI or OCI.
Some countries use other terms such as Unrealized holding gains/losses
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Accumulated Other Comprehensive Income (AOCI)

AOCI
An equity component in BALANCE SHEET Ending AOCI = Beginning AOCI + OCI of the current period

Similar to Retained Earnings account

Both are equity components in balance sheet Ending R/E = Beginning R/E + Net Income of the current period

Exercise: BE4-12
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Income Statement: Uses and Limitations

P4-12 The following is from a recent income statement for Baring Corp (a public company).

Instructions (a) Indicate the deficiencies in the income statement. (b) What recommendations would you make to the company to improve the usefulness of its income statement? (c) Why do some businesses provide only a minimal disclosure of financial statement elements on their income statement?
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Usefulness of Income Statement

Provide information RELEVANT for decision making
Predictive value Feedback value

Performance evaluation Persistent vs. non-persistent earnings Return and risk

Return: level of earnings Risk: volatility of earnings

And more

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Limitations
Income numbers are affected by the accounting estimates that are used
e.g. number of years for amortization

Income numbers are affected by the accounting choices/methods that are used
Subjective Will significantly affect the reported income

Exclusion of important accounting information

Cannot be measured reliably (e.g. contingent gains) Cannot be measured at all (e.g. human resource) Managers DO NOT WISH TO MEASURE (managers can enter into or avoid transactions with the primary purpose of affecting the reported results)

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Quality of Earnings
Characteristics of high quality earnings: 1. Nature of Content
Unbiased and determined objectively Represents economic reality Reflects earnings from ongoing operations Can be correlated with cash flows from operations Based on sound business strategy/model Transparent (Does not disguise or mislead) Understandable
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2. Presentation

Section 2
Statement of Retained Earnings (PE GAAP) and Statement of Shareholders Equity1 (IFRS)
Also called Statement of Owners Equity, Statement of Equity, Statement of Change in Shareholders Equity
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Reporting Irregular Items Statement of Equity

Some irregular items are included in income statement e.g. gains and losses from discontinued operations, gains and losses from extraordinary items, Some irregular items are included in the equity statement 1. Prior years income errors 2. Retroactive changes in accounting policies Under PE GAAP, these items are recorded as adjustments on the Statement of Retained Earnings Under IFRS, these items are detailed in the Statement of Changes in Equity
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Changes in Accounting Policies

Also called changes in accounting principle/methods Two scenarios
Mandatory change: change as required by GAAP Voluntary change: violation of consistency principle; therefore justifications must be made by the firm

Require the effects of the change on financial statements be reflected in financial statements RETROACTIVELY (Detail in Ch21)
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Errors from Prior Years

Example: Bad debt expense is understated by $9,000 in the prior year. First step is to decide whether such error should be adjusted If the answer is yes, the next step is to decide the accumulative effects of the error (net of tax) and the effects on each of the previous comparative year. In sum, the adjustment is RETROACTIVE and the rule is exactly the same as the adjustment of change in accounting policy (Detail in Ch21)
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Materiality principle

Statement of Retained Earnings (PE GAAP)

Beginning Retained Earnings Correction for prior year errors Adjustment for acct policy chg. Adjusted beginning Ret./Ear. Add: net income Less: dividends distribution Ending Retained Earnings $ xx, xxx (x,xxx) (xx,xxx) $ xx, xxx x,xxx (x,xxx) $xx,xxx
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Statement of Shareholders Equity (IFRS)

1. Illustration 4-17 (p.180)
Accumulated other Retained comprehensive Earning income $50,000 110,000 $60,000 30,000 $160,000 $90,000

Total Beginning balance Net income Other comprehensive income Comprehensive income Ending balance $410,000 110,000 30,000 $550,000

Common shares $300,000

Comprehensive income

$110,000 30,000 $140,000 $300,000

2. E4-17 (Wileyplus)
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