ACCT30001 Lecture Notes - Lecture 4: Financial Statement, Umber, Human Capital
28 May 2018
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FAT: Lecture 7 and Lecture 8
à outcome of recognition and measurement
à how to classify income
Purpose of statement of profit or loss:
- depict return that an entity had made on its economic resources during the period
- provide information that is helpful in assessing prospects for future cash flows and in
assessing management’s stewardship of entity’s resources
return ==> return on capital employed.
given this amount of resources that the firm has under their control, what is there return on
that amount that they generated? and in this way we can compare a company with a large
amount of resources under their control with a company to small amount of resources
under their control. ==> so you look at return. ROE.
it is mandated that they do that ==> in practice we do that but it is not written that we do
that.
True (ideal) net income
= change in wealth (firm value) between t and t-1
à income = change in present-value of future receipts during period
à like return on security which includes both dividends and capital appreciation
Non-existence of true net income
= change in wealth (value) between t and t-1
à don’t know true wealth because PV estimates are subject of substantial error and
markets are incomplete
Two conceptual approaches to measurement of income
* can’t apply concepts as don’t know true value as can’t measure assets/liabilities and don’t
know true value
* income statement can provide some information to help value (matching) [balance sheet
as storage as matching depreciation and revenue]
Asset/liability view of income measurement
- income is measure of increase in net resources of the enterprise during a period, defined
primarily in terms of increases in assets and decreases in liabilities
à balance sheet has conceptual primacy
in the current conceptual framework and current accounting standard community ==> they
view that BS should be the primarily statement guiding our recognition to measurement
principles.
The reason the balance sheet should have primacy is that:
because we can develop very clear principles as to whether the asset and liability exists. it is
easy to define principle as to what an asset is and when it exists. Because we can define
principles in the BS, as to when an asset exists. because we can define what an asset is and
what a liability is and everything that changes will go to the P&L.
Revenue/expenses and matching view of income measurement
- revenue recognition principle and matching of expenses to revenue principle are guiding
principles
- income statement has conceptual primacy and balance sheet is store of unallocated costs
in an ideal world, in which we can perfectly/reliably measure the assets and liabilities, you
are correct.
But we live in very unideal world, we do not know the assets and liabilities the firm has and
if we did know we cannot measure the value of those. At a pragmatic level, we cannot apply
these concepts of assets and liabilities.
However, IS can provide some information to the investment community of economic value
added , if we had the P&L as a primary statement.
what practitioner are interested in ( the valuation community, analyst), they are interested
in the economic value added by the firm and the return generated by the firm. And perhaps
the role of an accountant should be to provide information (additional information) to assist
investors in valuing the firm, so in that context the P&L should be the primarily statement.
Let’s provide an input, some measures, the economic value added. So the P&L should be the
primarily statement, the statement that everybody follows in practice.
Income concepts for valuation
Permanent income: stable average income a business expects to earn over its life given the
current state of business conditions
à estimate of component that will persist in the future
Valuation is all about expected future cash flows? so you want to know the income that is
going to persist into the future.
we want some measure of permanent income ==> we are trying to measure the value of the
stock so we need estimates of future cash flows ==> estimates persistent cash flows.
Otherwise refer to permanent income.
Operating income: refers to income that arises from companies operating activities
à excludes all expenses and income that arises from firms financing activities such as
interest expense and investment income
operating income ==> the nature of the firm that it raises funds from financing (
debt/equity) then Invest those in project and prime role of the firm is to operate that
project and produce goods and services and generate a return on the production of those
goods or services. The firm add value from its operating side not from its financing side.
Permanent, transitory and value irrelevant components of accounting income
- different components of earnings can have different persistence
à consider income statement and split into different earnings streams
Three types of earnings events:
- permanent (or recurring): expected to persist indefinitely
eg. recurring income
- transitory (or nonrecurring): affecting earnings in current year only
eg. gains on sales
- price irrelevant: have no economic content and have zero effect on company value
eg. accounting paper gain/loss (change of depreciation method)
current reported income can be a combination of 3 types: lets assume we currently
reported $100 of income.
_ $90 of that 100 most likely would be persistent and most likely will occur again next year
==> permanent income
_ $6 transitory nonrecurring , once off gain, definite economic gain but it is once off. The
usual example of that is for example, the gain on the sale of some land.
_ $4, example of reported income in 2017 financial reports ==> that is irrelevant, you would
not include in the stock price.
How is income reported
Requirements by accounting standards (GAAP income)
AASB 101 presentation of financial statements
- present profit or loss, total other comprehensive income, comprehensive income for
period (total of profit or loss and OCI)
Important thing to understand is what those metrics are and why are they being reported?
because the incentive behind it tells you how you are supposed to use it.
Components of OCI
- income and expenses that are specifically required to be in OCI and not in P&L
- revaluation gains relating to PPE or intangible assets
- re-measurements of defined benefit obligations
- gains and losses arising from translating financial statements of foreign operation
- gains and losses on remeasurement available for sale financial assets
- effective portion of gains and losses on hedging instruments in a cash flow hedge
There is no definition of OCI in the accounting standards:
if you have an unrealised gain, that must go through OCI.
what about it you have a loss? it has to go to the P&L. Why? conservatism.
1. unrealised
2. they represent changes in value in the firms assets and liabilities and they are unrealised.
Motivation for reporting OCI
- enhance relevance of information in statement of profit and loss for period
- classifying items as income and expenses arising from transactions and events separately
from changes in value can provide useful information
if you are expecting future cash flows coming from the operating side of the business. i.e.
we are not going to sell these assets to realize that gain.
EPS
à measure of profitability because it shares same denominator as price per share
à indicates income earned by each ordinary share (used to value a share)
à PE ratio is measure of future earnings prospects of company
à calculated by dividing some measure of earnings by some umber represented shares on
issue eg. (price per share/earnings per share)
Calculated in two different ways:
1. Basic earnings per share
à divide earnings [profits after tax deducting portions attributable to non-controlling
interest and preference share dividends) for financial year by average weighted number of
Document Summary
Depict return that an entity had made on its economic resources during the period. Roe. it is mandated that they do that ==> in practice we do that but it is not written that we do that. = change in wealth (firm value) between t and t-1. Income = change in present-value of future receipts during period. Like return on security which includes both dividends and capital appreciation. = change in wealth (value) between t and t-1. Don"t know true wealth because pv estimates are subject of substantial error and markets are incomplete. * can"t apply concepts as don"t know true value as can"t measure assets/liabilities and don"t know true value. * income statement can provide some information to help value (matching) [balance sheet as storage as matching depreciation and revenue] Income is measure of increase in net resources of the enterprise during a period, defined primarily in terms of increases in assets and decreases in liabilities.
