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University of Waterloo
Accounting & Financial Management
AFM 291
Kareen Brown

CHAPTER 4 REPORTING FINANCIAL PERFORMANCE All Business is based on business model of getting cash, investing it in resources, and then using these resources to generate profits • Three distinct types: 1. Financing : obtaining cash funding, often by borrowing, issuing shares, or retaining profits; also the repayment of debt and/or repurchase of shares 2. Investing: using the funding to buy assets and invest in people; divestitures 3. Operating: using the assets and people to earn profits • Balance sheet aims to capture the financing and investing activities • Income statement aims to capture the operating and performance-related activities • Cash flow statement looks at the interrelationship between the activities 1. Identify the uses and limitations of an income statement • Income statement a.k.a. the statement of earnings or statement of income, is the report that measures the success of a company’s operations for a specific time period • Determines profitability, investment value, and creditworthiness • Provides investors and creditors with info. that helps them allocate resources and assess management stewardship • Usefulness: o Investors and creditors can use the info. in the income statement to: evaluate the enterprise’s past performance and profitability; provide a basis for predicting future performance; help assess the risk or uncertainty of achieving future cash flows • Limitations: o Income statement includes a mix of hard numbers (easily measured with a reasonable level of certainty) and soft numbers (more difficult to measure) o Items that cannot be measured reliably are not reported in the income statement o Income numbers are affected by the accounting methods that are used o Income statement involves the use of the estimates Quality of Earnings • The nature of the content and the way it is presented • When analyzing earnings information look at: Contents which includes (a) the integrity of the information, including whether it reflects the underlying business fundamentals (b) the sustainability of the earnings; Presentation which means a clear, concise manner that makes it easy to use and understandable • Accountant’s perspective, ensure that the info. is unbiased, reflects reality, and is transparent and understandable • Capital market’s perspective, earnings must be sustainable—earnings numbers may be judged to be of a higher (more reliable, with a lower margin of potential misstatement, and are more representative of the underlying business and economic reality) quality or a lower quality • Companies with higher-quality earnings are attributed higher values by the markets • Earnings management defined as the process of targeting certain earnings level (whether current or future) or desired earnings trends and then working backwards to determine what has to be done to ensure that these targets are met (can involve the selection of accounting and other company policies, the use of estimates, and even the execution of transactions) o can be used to increase/decrease current earnings by reducing/increasing the future earnings Format of the Income Statement • Elements of the income statement: revenues, expenses, gains, losses, and other comprehensive income (pg.145) o Distinction between revenue and gain depends on how the enterprise’s ordinary or typical business activities are defined • It is transaction-based because it focuses on the income-related activities that have occurred during the period 2. Prepare a single-step income statement (pg.148) • Only main two groups are used: revenues and expenses • Used in small and private companies • Advantage: the presentation is simple and no one type of revenue or expense item is implied to have priority over any other 3. Prepare a multiple-step income statement (pg.149) • Used among public companies • Also includes: o a separation of the company’s operating and non-operating activities (i.e. other revenues and gains and other expenses and losses) o Classification of expenses by functions, such as merchandising or manufacturing (cost of goods sold), selling, and administration—makes possible to immediately compare costs of previous years and costs of different departments during the same year • A study in trend of gross profits show how successfully a company uses its resources; also be a basis for understanding how profit margins have changed as a result of competitive pressure • Disclosing income from operations highlights the difference between regular and irregular or incidental activities (discontinued operations or extraordinary items included at the bottom of the statement) • Intermediate components of the income statement (pg.150) o Continuing operation:  Operating (sales or revenue, COGS, selling exp., and admin. or general exp.)  Non-operating (other revenues and gains, other exp. and losses)  Income tax o Discontinued operations o Extraordinary items o Other comprehensive income • Condensed income statement (pg.152) o Include only the totals of the expense groups in the statement of income and prepare supplementary schedules of expenses to support the totals 4. Explain how irregular items are reported • Currently, statement must follow all-inclusive approach except: o Errors in the income measurement of prior years; o Changes in accounting policies that are applied retroactively • Some use current operating performance approach to income reporting o Most useful income measures are the ones that reflect only regular and recurring revenue and expense elements—the
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