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FINANCIAL ACCOUNTING

THEORY AND ANALYSIS:


TEXT AND CASES
11TH EDITION

RICHARD G. SCHROEDER
MYRTLE W. CLARK
JACK M. CATHEY
CHAPTER 6

Financial Statements I:
The Income Statement
Introduction
Various groups are affected by, and have a stake in, the financial
reporting requirements of the FASB and the SEC
Introduction
Investors in equity securities are the central focus of
the financial reporting environment
Introduction
Investing involves
Giving up current resources

For future uncertain resources.

Therefore, investors require information assessing


future cash flows.
The Economic Consequences of
Financial Reporting
Financial reporting has economic consequences including:
1 Financial information can affect the distribution of wealth among investors.
More informed investors, or investors employing security analysts, may be able to
increase their wealth at the expense of less informed investors.
The Economic Consequences of
Financial Reporting
2 Financial information can affect the level of risk accepted by a
firm.
Focusing on short-term, less risky, projects may have long-term
detrimental effects.

3 Financial information
Can affect the rate of capital formation in the economy
And result in a reallocation of wealth between consumption and investment within the
economy.
The Economic Consequences of
Financial Reporting

4 Financial information can affect how investment is allocated among firms.

These economic consequences may have a differential impact on different user


groups and future deliberations of standards must consider these economic
consequences
Income Statement Elements

SFAC No. 8 indicates that the primary


focus of financial reporting is to
provide information about a
companys performance
Income Statement Elements
Vehicle for relaying performance assessments to
investors
SFAC No. 6: defined the elements of the income
statement
Revenues
Gains
Expenses
Losses
Each Term Is Defined As Changes in
Assets and Liabilities
Differences between changes in assets approach and inflow and outflow
definition are:

1. Determining Earnings

Change in net economic VS Views as a measure of


resources effectiveness

2. Defining Earnings

Definition of Assets and VS Definition of Revenue &


Liabilities Expenses

3. Creating deferred charges


Recognized only when VS Created as a result of
they are economic measuring income
resources or obligations
Each Term Is Defined As Changes in
Assets and Liabilities

4. Both agree on importance of income statement


5. Population from which the elements of financial statements can be
selected

Net economic resources and to


the transactions and events Items necessary to
that change measurable VS match revenues and
attributes of those net costs
resources
Statement Format
The preparation of the income statement
has been impacted by differences of
opinion on the definition of ongoing
operations.
Two views:

1 All inclusive
2 Current operating performance
Current Income Statement Format

Proscribed in APB Opinion No. 9 as:


Revenues
Less: Cost of goods sold
= Gross profit
Less: Administrative and selling expenses
Plus: Other gains
Less: Other losses
Excludes prior-period
= Income from continuing operations adjustments
Discontinued operations
Extraordinary items
Change in accounting principle

= Net income
Income From Continuing Operations

Normal and recurring revenues and expenses


Sustainable income
Income tax (recurring items)
Nonrecurring items (Each net of their tax effect)
Discontinued operations
Extraordinary items
Change in accounting principle
Tootsie Roll and Hershey

Tootsie Roll Industries and The Hershey Company


are internationally known candy manufacturers.

We will use information from the two companies fiscal 2007 -


2011 annual reports to illustrate the disclosure of information
in this and subsequent chapters.
Discontinued Operations
Why special treatment?
Arise from a disposal of a component of a business
Comprising operations and cash flows that can be clearly
distinguished, operationally and for financial reporting
purposes, from the rest of the entity.
Original criteria contained in APB Opinion No. 30.
This release required the separate presentation of (1) the results of
operations of the disposed segment, and (2) gain or loss on the sale of
assets for disposed segments including any operating gains or losses
during the disposal period.
Time of disclosure was determined by whether a gain or loss was
expected on the measurement date
Amended by SFAS 144
SFAS No. 144 FASB ASC 360

Changed reporting of discontinued operations:


Unit must qualify as a component (distinguishable
assets and cash flows
If so:
Operations and cash flows of component must be eliminated
as a result of the transaction
Company does not retain any significant involvement in
operations of component after disposal
Neither Hershey or Tootsie Roll disclosed any
discontinued operations
Accounting for Discontinued Operations
Under Continuing Review
FASB Exposure Draft
September 2008
Amending the Criteria for Reporting a Discontinued Operation
IASB Exposure Draft
Discontinued Operations
Definitions in SFAS No. 144 and IFRS No. 5 not
convergent
Proposed definition:
An operating segment that has been disclosed of or is
up for sale; or
A business that meets the criteria to be classified as
held for sale on acquisition.
Discontinued Operations FAS 2013-46
Subsequent to the publication of this text, the FASB issued a FAS 2013-46
which changed the criteria for determining disposals to be presented as
discontinued operations.
The new definition of a discontinued operation is a component or group of components that
has been disposed of or is classified as held for sale, together as a group in a single
transaction, and represents a strategic shift that has (or will have) a major effect on an entity's
financial results.
A business that, upon acquisition, qualifies as held for sale will also be a discontinued
operation.
Entities are required to disclose the operating and investing cash flows for
discontinued operations.
For disposals of individually material components that do not qualify as discontinued
operations, the board decided to require disclosures of pre-tax profit or loss of the disposed
component and the amount attributable to the parent if there is a noncontrolling interest.
Public entities will be required to apply the guidance in annual periods
beginning on or after December 15, 2014, and interim periods within those
annual periods.
Nonpublic entities will be required to apply the guidance within annual
periods beginning on or after December 15, 2014, and interim periods
thereafter.
Extraordinary Items
Original definition APB No. 9 not expected to recur
Problems similar items not being classified similarly
APB Opinion No. 30
Unusual nature
Infrequency of occurrence
Problem:
Requirements do not always separate recurring and non-recurring
items unusual but not infrequent
As a result, there is a tendency to increase the variability of operating
income and decrease the predictive ability of earnings
The events of 9/11
Neither company discloses any extraordinary items for the years
presented
Accounting Changes

The accounting standard of consistency requires that similar


transactions should be reported similarly each year
Occasionally an entity may find that reporting needs are better served
by changing a method of accounting
If so, the comparability of financial statements is impaired
Basic question: Should previously issued financial statements be
amended?
Accounting Changes
APB Opinion No. 20 originally identified
four types of accounting changes:
1. Change in an accounting principle
Occurs when an entity adopts a GAAP that differs from one previously used for
reporting purposes.
2. Change in an accounting estimate
Result from the necessary consequences of periodic presentation.
3. Change in a reporting entity
Caused by changes in reporting units, which may be the result
a. Consolidations,
b. Changes in specific subsidiaries, or a
c. Change in the number of companies consolidated.
4. Errors
Not viewed as accounting changes.
Result of mistakes or oversights such as the use of incorrect accounting methods
or mathematical miscalculations.
Types of Accounting Changes
Change in accounting principle
How reported
APB Opinion No 20 Catch-up adjustment with 3 exceptions
SFAS No 154 Retrospective application

Change in accounting estimate


How reported Prospective application
Change in accounting entity
How reported- Retrospective application
Errors
How reported Prior period adjustments
Earnings Per Share

Basic calculation
Net income - Preferred dividends
Average # of common shares outstanding

APB No. 9 concept of residual and senior securities


APB No. 15
Simple vs. complex capital structure
Required calculation of primary and fully diluted earnings per share
The concept of common stock equivalents

Criticism of APB No. 15 - arbitrary, complex and illogical


The FASB and IASC project
SFAS No. 128
Reasons for the change
1 Basic EPS and diluted EPS data would give users the most factually range of
possibilities
2 Use of a common international method is important due to the data based
oriented financial analysis and internationalization of business
3 The notion of common stock equivalents does not operate efficiently in practice
4 The computation of primary EPS is complex and not well understood or
consistently applied
5 Presenting basic EPS eliminates criticism about the arbitrary nature of the
determination of common stock equivalents
SFAS No. 128
Requires presentation of EPS by all publicly traded
companies issuing common stock
Companies with a simple capital structure will only report
basic earnings per share. All others will report basic and
diluted
Calculation of basic EPS

Net income - Preferred dividends


Average # of common shares outstanding
Diluted Earnings Per Share
Objective
Historical - basic
Pro forma - diluted
Calculation:
Includes all potential dilutive securities
1. Options and warrants - treasury stock method
2. Written put options reverse treasury stock method
3. Convertible securities
as-if-converted
4. Contingently issuable securities
Usefulness of EPS
Objectives of EPS reporting are to provide investors an indication of:
1 Value of the firm
2 Expected future dividends

Question: Historical or forecasted?


Summary indicator
Hershey has a complex capital structure and discloses basic as well
as diluted earnings per share on its income statements
Tootsie Roll has a simple capital structures and discloses only one
earnings per share figure
SFAS No 130 - Reporting
Comprehensive Income
Reasons for the initial project
1 Off-balance sheet financing
2 The practice of reporting some items of
comprehensive income in
stockholders equity
3 Acknowledged need for harmonization
of accounting standards
Definitions

Comprehensive income
The change in equity (net assets) of a business
enterprise during a period from transactions and other
events and circumstances from nonowner sources.
Other comprehensive income
Revenues, expenses, gains, and losses included in
comprehensive income but excluded from net income.
SFAS No 130 - Reporting
Comprehensive Income

Original issues:
1. Should comprehensive income be reported?
2. Should cumulative accounting adjustments be included in
comprehensive income?
3. How should the components of comprehensive income be classified for
disclosure?
4. How should comprehensive income be disclosed
in the financial statements?
5. Should the components of other comprehensive
income be disclosed before or after their related
tax effects?
Should Comprehensive Income Be
Reported?

SFAS No 130
Requires the disclosure of comprehensive
income and
Discusses how to report and disclose
comprehensive income and its components,
including net income.
Does not specify when to recognize or how to
measure components
Should Cumulative Accounting
Adjustments Be Included?

Include As Part Of
Cumulative Accounting Comprehensive Income
Adjustments

Cumulative
Accounting
Adjustments
How Should the Components of
Comprehensive Income Be Classified
for Disclosure?
Requirement:
Companies must disclose an
amount for net income
That amount must be accorded equal
prominence with the amount disclosed for
comprehensive income
Items of other comprehensive income are
classified based on their nature
How Should Comprehensive Income be
Disclosed in the Financial Statements?

Requires a gross disclosure technique for


items of other comprehensive income
ASU 2011-05 allows for the disclosure of
comprehensive income
On income statement
On a separate statement
Previous alternative treatment of disclosure in statement of
stockholders equity no longer allowed
Should Components of Other Comprehensive
Income Be Displayed Before or After Their
Related Tax Effects.
Allows the components of other comprehensive income
to be disclosed either
Net of related tax effects or
Before related tax effects with one amount shown for the
aggregate income tax expense or benefit related to the total
amount of other comprehensive income
Other comprehensive income is transferred to a
separate component of stockholders equity
Hersheys discloses changes in other comprehensive
income in its consolidated statement of shareholders
equity as a single net amount. (No longer allowed)
Tootsie Roll includes the calculation of other
comprehensive income on its income statement.
Prior Period Adjustments
An adjustment to beginning retained
earnings balance
Original criteria in APB No. 9
Examples were income tax
disputes and litigation
SEC Staff Bulletin No. 8
and APB Opinion No. 16
Correction of an error
Adjustments from realization of operating loss carryforward
of purchased subsidiary
PROPOSED FORMAT OF THE STATEMENT OF
COMPREHENSIVE INCOME

Under Phase B of the financial statement presentation


project the FASB and the IASB are planning to release a
plan to recast financial statements into a new format.
One possible result is the elimination of the current definition of
net income.
In its place, financial statement users may find a number of profit
figures that correspond to different corporate activities.
The rationale for the new presentation is that focusing on the net
profit number has been seen as one cause for the fraud and
stock-market excesses that characterize the past several years.
PROPOSED FORMAT OF THE STATEMENT OF
COMPREHENSIVE INCOME

The new proposed income statement has separate


categories for the disclosure of a companys operating
business, its financing activities, investing activities, and
tax payments.
Each category also contains an income subtotal.
The proposal adopts a single statement of comprehensive
income format that combines income statement elements and
components of other comprehensive income into a single
statement.
Items of other comprehensive income are to be presented in a
separate section following the income statement elements
Proposed Format of Statement of
Comprehensive Income
Separate categories for disclosure of
Operating business activities
Financing activities
Investing activities
Tax payments
Subtotal for each category
All income and expense items to be classified into operating,
investing, and financing
Disaggregate line items by function
Function: the primary activities in which an entity is engaged
Further disaggregate line items by nature
Nature: the economic characteristics or attributes that distinguish assets, liabilities, and income and
expense items that do not respond equally to similar economic events
The Value of Corporate Earnings

The financial analysis of a companys income


statement focuses on a companys operating
performance by focusing on such questions as:
1. What are the companys major sources of revenue?
2. What is the persistence of a companys revenues?
3. What is the companys gross profit ratio?
4. What is the companys operating profit margin?
5. What is the relationship between earnings and the market
price of the companys stock?
Sources of Revenue

The financial analysis of a diversified company requires a


review of the impact of various business segments on the
company as a whole.
Hershey reports segmental information for two segments:
Domestic
International
Tootsie Roll reports segmental information for two
segments:
Domestic
International
Neither company discloses any information about major
customers.
Persistence of Revenues
5-Year Revenue Trend Analysis

140.0% 122.9%
100.0% 107.1% 114.6%
103.8% 107.0%
120.0% 104.8%
100.0% 100.0% 100.3%
100.0%
80.0%
60.0%
40.0%
20.0%
0.0%
2007 2008 2009 2010 2011

Hershey Tootsie Roll


Managements Discussion
and Analysis
The MD&A section of a companys annual report can provide
valuable information on the persistence of a companys earnings
and its related costs.
SEC requires companies to disclose any changes or potential
changes in revenues and expenses to assist in the evaluation of
period-to-period deviations.
Both Hershey and Tootsie Roll indicated decrease in gross profit
percentage from 2010 to 2011
Gross Profit Analysis
Gross Profit Percentage = Gross profit net sales

5-Year Gross Profit Trend Analysis

50.0% 42.6% 41.6%


38.7%
33.0% 34.2%
40.0% 33.9%
35.8% 31.2%
32.6% 32.8%
30.0%

20.0%

10.0%

0.0%
2007 2008 2009 2010 2011

Hershey Tootsie Roll


Net Profit Analysis
Net Profit Percentage = Net Income Net Sales

5-Year Net Profit Trend Analysis

20.0%

15.0% 10.3%
10.4% 10.6% 10.2%
10.0% 8.2% 9.0% 8.3%
6.1% 7.8%
4.3%
5.0%

0.0%
2007 2008 2009 2010 2011
Hershey Tootsie Roll
Operating Profit Percentage
Operating Profit Percentage = Operating profit Net Sales

5-Year Operating Profit Analysis

20.00 17.40 17.30


14.90 15.90
14.20 13.30 15.00
15.00 13.40
12.40 10.90

10.00

5.00

-
2007 2008 2009 2010 2011
Hershey Tootsie Roll
The Value of Corporate
Earnings
The relationship between corporate earnings
and stock prices
Measured by price earnings ratio
P/E Ratio = Current market price per share EPS

Hershey = 21.68
Tootsie Roll = 31.14
Price-Earnings Ratios
Operating Profit Percentage = Operating profit Net Sales

5-Year Price-earnings ratio Analysis

50.00 45.39
37.66
40.00 31.14
30.80 32.19
30.76
30.00 25.35
18.17 20.59 21.68
20.00
10.00
-
2007 2008 2009 2010 2011
Hershey Tootsie Roll
International Accounting Standards

In addition to release of IAS No. 33 on EPS, IASB has:


1. Defined the concepts of performance and income in Framework for the
Preparation and Presentation of Financial Statements
2. Discussed the content and format of the income statement in IAS No. 1,
Presentation of financial Statements
3. Discussed some components of the income statement in an amended IAS No. 8,
now titled "Accounting Policies, Changes in Accounting Estimates and Errors"
4. Defined the concept of revenue in IAS No. 18, Revenue
5. Amended IAS No. 33
6. Discussed the required presentation and disclosure of a discontinued operation in
IFRS No. 5, Non-Current Assets Held for Sale and Discontinued Operations
7. Issued a proposed amendment to IAS No. 1
IASB Definitions of Performance and Income

Profit is used
To measure performance
Or as the basis for other measures

Measurement of income is
dependent on
The concept of capital maintenance used by the
enterprise
Physical capital maintenance
Financial capital maintenance
IASB Definitions of Performance and Income

The IASB definition of income


encompasses both revenue and
expenses
The IASB has not made the
distinction between ordinary and
nonordinary operations contained in
SFAC No. 6
A proposed standard would require a Statement of
Non-owner Movements in Equity
Encourages an analysis of income and expenses based
on their nature or function in the enterprise
International Accounting Standards
IAS No. 1
Requires income statement that includes
Revenue
Results of operations
Finance costs
Gains & losses from equity investments
Tax expense
Profits or losses from ordinary activities
Minority interest
Net profit
Does not require discontinued operations or
accounting changes to be reported separately
Does not allow items to be classified as ordinary
IAS No. 8: Accounting Policies, Changes in
Accounting Estimates and Errors

Originally, IAS No. 8


Defined the concepts of
Net profit or loss from ordinary activities
Extraordinary items
Accounting changes
Fundamental errors
Each of these income statement items was
defined and reported in a manner similar to U.S. GAAP
with the exception of fundamental errors
The revised IAS No. 8
Does not distinguish between ordinary and extraordinary items
Eliminates the concept of fundamental errors
IAS No. 8: Accounting Policies, Changes in
Accounting Estimates and Errors
A GAAP hierarchy indicates that the following sources must
be applied in descending order of authoritativeness:

International Financial Reporting Standard, including any


appendices that form part of the Standard

Interpretations

Appendices to an IFRS that do not form part


of the Standard

Implementation guidance issued by IASB in


respect of the Standard
IAS No. 8: Accounting Policies, Changes in
Accounting Estimates and Errors
Errors
Now defined as newly discovered omissions
or misstatements of prior period financial
statements based on information that was
available when the prior financial statements
were prepared
All material errors will be accounted for
retrospectively
By restating all prior periods presented
And adjusting the opening balance of retained
earnings of the earliest prior period presented
Cumulative effect recognition in income is
prohibited
IAS No. 18 - Revenue
Revenue should be recognized when:
1 The enterprise has transferred to the buyer
the significant risks and rewards of
ownership of goods
2 The enterprise doesnt retain managerial
involvement or control over the goods sold
3 The amount can be measured reliably
4 It is probable that economic benefits associated with
the transaction will flow to the enterprise
5 The costs associated with the transaction can be
measured reliably
IAS No. 18 - Revenue
U. S. GAAP does not specifically address the issue of
revenue
If it did, there would probably be a difference because of the
IASC use of the term probable future economic benefit
IAS No. 35: Discontinued Operations

The amended IAS No. 33 incorporated the following additional


disclosures and guidelines:
1. Basic and diluted EPS must be presented for
(a) Profit or loss from continuing operations and
(b) Net profit or loss
on the face of the income statement for each
class of ordinary shares, for each period
presented.
2. Potential ordinary shares are dilutive only when their
conversion to ordinary shares would decrease EPS from
continuing operations
(IAS 33 previously used net income as the benchmark).
IAS No. 35: Discontinued Operations

3. For contracts that may be settled in cash or


shares, now includes a rebuttable presumption
that the contract will be settled in shares.
4. If an entity purchases (for cancellation) its own
preference shares for more than their carrying
amount, the excess (premium) should be treated
as a preferred dividend in calculating basic EPS (deducted from the
numerator of the EPS computation).
5. Guidance is provided on how to calculate the effects of contingently
issuable shares; potential ordinary shares of subsidiaries, joint ventures,
or associates: participating securities; written put options; and purchased
put and call options.
IFRS No. 5: Non-Current Assets Held for
Sale and Discontinued Operations

SFRS No. 5 replaces IAS No. 35.


Discontinued operations

Post-tax profit Post-tax gain or Cost to sell or


or loss of the
discontinued
operation
+
loss recognized
on the
measurement to
fair value
- fair value
adjustments on
the disposal of
the assets (or
disposal group)

Should be presented as a single amount on the face


of the income statement
IFRS No. 5: Non-Current Assets Held for Sale
and Discontinued Operations

Detailed disclosure of revenue, expenses, pre-tax profit or loss, and


related income taxes is required
Either in the notes or on the face
of the income statement in a
section distinct from continuing
operations.
Such detailed disclosures must
cover both the current and all
prior periods presented in the
financial statements.
IFRS No 5 prohibits the retroactive
classification as a discontinued operation, when the discontinued
criteria are met after the balance sheet date.
Proposed Amendment to IAS No.1
Similar to the FASBs proposed Accounting Standards
Update on the Statement of Comprehensive Income;
however, there are some differences.
The IASB chose to title the new statement The Statement of
Profit or Loss and other Comprehensive Income.
The new guidance would not change those components that are
recognized in other comprehensive income under either
accounting framework
Additionally, the two frameworks differ on the treatment of some
of those components and total convergence not achieved.
The Boards believe that the proposals are an important step in
enhancing comparability and providing greater transparency.
End of Chapter 6

Prepared by Kathryn Yarbrough, MBA

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