Intermediate 1 Chapter 5 Class Notes
Intermediate 1 Chapter 5 Class Notes 3310
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This 10 page Class Notes was uploaded by Emily Sears on Tuesday January 26, 2016. The Class Notes belongs to 3310 at Auburn University taught by Dr. Duane Brandon in Spring 2016. Since its upload, it has received 112 views. For similar materials see Intermediate Accounting I in Accounting at Auburn University.
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Date Created: 01/26/16
CHAPTER 5: The Income Statement and Statement of Cash Flows Purpose of the Income Statement Evaluate the profitability and assess the return on investment in the company Assess the company’s operating capability and financial performance for the current period and over time Evaluate management’s past performance Predict the company’s future income and cash flows Understand the components of income Assess the company’s risk Help in comparisons with other companies Assess the impact of economic factors on the company Many users consider the income statement to be the most important statement Elements of the Income Statement Revenues- inflows of (increases in) assets of a company or settlement of its liabilities during a period from delivering or producing goods, rendering services, or other activities that are the company’s ongoing major or central operations Expenses- outflows of (decreases in) assets of a company or incurrences of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that are the company’s ongoing major or central operations Gains- increases in the equity (net assets) of a company from peripheral or incidental transactions, and all other events and circumstances during a period, except those that results from revenues or investments by owners Losses- decreases in the equity (net assets) of a company from peripheral or incidental transactions, and all other events and circumstances during a period, except those that result from expenses or distributions to owners When should revenues be recognized? A company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. 5 step recognition process: 1. Identify contract with customer 2. Identify performance obligations 3. Determine transaction price 4. Allocate transaction price to performance obligations 5. Recognize revenue when (or as) the entity satisfies performance obligations When should expenses be recognized? Expense recognition principles: 1. Association of cause and effect- presumed to be directly related to specific revenues (COGS, sales commissions) 2. Systematic and rational allocation- allocate among periods in which benefits are provided (depreciation, allocation of prepaid costs) 3. Immediate recognition- recognize in current period (management salaries, R&D costs, SG&A costs) When should gains/losses be recognized? Categories of gain/loss recognitions: 1. Exchange transaction (sale of used equipment) 2. Holding of resources or obligations while their values change (inventory write-downs, impairments of PP&E) 3. Nonreciprocal (“one-way”) transfers between a company and non-owners (gains/losses arising from lawsuits, court fines, natural catastrophes) Income Statement Components 1. Income fromcontinuing operations Sales revenue (net of sales returns, allowances, & discounts) Cost of Goods Sold Gross profit (margin) Operating expenses (SG&A, depreciation amortization, R&D) Income from operations Other revenue, gain, expense, loss items Income from continuing operations before tax Income tax expense (provision) related to continuing operations Income from continuing operations 2. Results from discontinued operations Income (loss) from operations of discontinued components (net income taxes) Gain (loss) from disposals of discontinued components (net of income taxes) 3. Net Income 4. Earnings per share See the all-inclusive income statement presented in Example 5.2 of text Income fromContinuing Operations Two acceptable formats for presenting income from continuing operations: 1. Multiple-step format- includes several classifications (example 5.2 in text) 2. Single-step- includes only two classifications, revenues and expenses (example 5.1 in text) Results fromDiscontinued Operations To be classified as a discontinued operation, the disposal must represent a strategic shift that has (or will have) a major effect on an entity’s operations and financial results. Examples of such strategic shifts include: disposal of a major geographic area, a major line of business, a major equity method investment, or other major parts of an entity “held for sale” criteria. Upon being classified as held for sale, the component will be valued at lower of cost or net realizable value (fair market value- estimated disposal costs) with any resulting loss treated as part of the net gain (loss) from operating the discontinued component in the current period. “Held for sale” criteria 1. Management has committed to a plan to sell the component 2. The component is available for immediate sale in its present condition 3. Management has begun an active program to locate a buyer 4. The sale is probable within one year 5. The component is being offered for sale at a price that is reasonable in relation to component’s fair market value 6. It is likely that management will make significant changes to the plan Example 1 Example2 Earnings Per Share Must report basic and diluted earnings per (common) share for 1. Income from continuing operations 2. Net Income 3. Discontinued Operations 4. Extraordinary Items Diluted EPS considers the (numerator & denominator) effect of securities that may be converted into shares of common stock in the future (ex: convertible preferred stock, convertible bonds, stock options) Comprehensive Income The FASB requires companies to report their comprehensive income (or loss) for the period by adding its other comprehensive income to its net income. Recall, comprehensive income is comprised of (1) net income and (2) other comprehensive income/ Other comprehensive income results from 1. Unrealized gains and losses in the fair value of AFS securities 2. Foreign currency translation adjustments 3. Certain gains and losses on derivative instruments, and 4. Certain pension liability adjustments Companies have two alternatives for reporting comprehensive income: 1. Present net income and comprehensive income in a single performance statement or 2. Present net income on the income statement and present comprehensive income on a separate, but consecutive, statement of comprehensive income. See examples on page 5-30 Statement of Cash Flows The Statement of Cash Flows helps external users assess: 1. The company’s ability to generate positive future cash flows 2. The company’s ability to meet its obligations 3. The company’s use of cash for capital expenditures and investments 4. The company’s need for external financing 5. The reasons for differences between the company’s net income and associated cash receipts and payments 6. The sources of cash from issuing shares and uses of cash to pay dividends and repurchase shares from common shareholders’ The Statement of Cash Flows includes three major sections: Cash flows from operating activities (ex: activities related to the earnings process) Cash flows from investing activities (ex: activities related to acquiring & selling investments, acquiring and selling property, plant, and equipment, and lending money and collecting on loans) Cash flows from financing activities (ex: activities related to obtaining and disbursing resources from and to owners and repaying the amounts borrowed) See example 5.4 Operating Cash Flows – Direct Method (DM is NOT commonly used) Operating Cash Inflows + Collections from customers + Interest and dividends collected Operating Cash Outflows – Payments to suppliers and employees – Payments of interest – Payments of income taxes = Cash Flow fromOperating Activities Operating Cash Flows – Indirect Method Net income +/- Eliminate items affecting net income but not operating cash flows (e.g., depreciation and amortization expense, gains/losses on disposal of investments and long-term assets/liabilities) – Increases in current asset accounts (other than cash) + Decreases in current asset accounts (other than cash) + Increases in current liability accounts – Decreases in current liability accounts = Cash Flow from Operating Activities A Very Simple Example of Indirect Method Overview of Facts Assume ABC starts operations on January 1 . During January it sells $400,000 of inventory to customers all on credit. Customers will pay for these sales in February. Also during January it purchased the inventory it sold at a cost of $195,000 and incurred other operating expenses of $50,000. All of the purchases and expenses were on credit and will not be paid until February. Remember, since the company began operations on January 1 the beginning balance in all accounts was $0. Since everything was on credit, the change in A/R was a $400,000 increase and in A/P a $245,000 increase. What is accrual net income for January? What is cash flow from operations in January? Accrual Income vs. Cash Flows Indirect Method Steps- January Facts For February In February ABC sold $500,000 all credit to be paid in March. It purchased the inventory it sold at a cost of $245,000 and had operating expenses of $70,000. All of the inventory purchases and expenses were on credit. Also during February, ABC collected $380,000 cash from customers and paid $185,000 to suppliers for prior credit purchases of inventory and $46,000 to others for prior credit purchases of operating expenses. What is accrual net income for February? What is cash flow from operations in February? Accrual Income vs. Cash Flows Indirect Method Steps- February T-Account Analysis- February Segment Reporting A company that has subsidiaries prepares its financial statements on a “consolidated” (aggregated) basis Disaggregation of total financial data also can be important in financial analysis because the level of risk, return on investment, and expected future earnings and cash flows may differ significantly across a company’s different operating segments The FASB, therefore, requires that a company’s financial statements include certain disaggregated information about its operating segments A component of a company is an operating segment if it: Engages in business activities to earn revenues and incur expenses Generates operating results regularly reviewed by the company’s chief operating decision maker to make decisions about allocating resources to the segment and assessing its performance Has discrete financial information available An operating segment is significant and is a separately reportable segment if it passes any of the three following tests: 1. Revenue test- its reported revenues are 10% or more of the combined revenues of all the company’s operating segments 2. Profit test- the absolute amount of its profit (loss) is 10% or more of the combined profits of all operating segments that did not report a loss 3. Asset test- its segment assets are 10% or more of the combined assets of all operating segments An overall materiality test also requires that reportable segments must be disclosed if their combined revenues are at least 75% of the entire company revenues. See example 5.5 in text for the types of info reported Interim Reporting Interim financial statements are reports for period of less than a year. The SEC requires registrants to file interim reports on a quarterly basis (using Form 10-Q) Interim reporting requirements raise several issues GAAP primarily addresses the following income statement items with respect to interim reporting: Revenues Operating expenses Income taxes Extraordinary items and discontinued operations Earnings per share Additional Notes Look at definition of Comprehensive Income on p. 5-5
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