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CA (170,000)
UTM (8,000)
Chapter 4

MGT220H5 Chapter 4: chapter 4 readings.docx


Department
Management
Course Code
MGT220H5
Professor
Kathy Falk
Chapter
4

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Chapter 4: Reporting Financial Performance
e.g. income = 800,000
x 40% = net income 32000  net income tax
2 types of financing in Canada – debt(bonds, bank loans) and equity (issue shares)
If there is an error in the prior period – correction made thru retained earnings  it is net of tax
Correction of errors in prior periods and effects to prior periods from accounting policy changes
are treated as prior period adjustments
BE 4-15
Global corp has elec
Income statement (aka comprehensive income) = report that measures success of
company’s operations for specific time period
3 business activities: financing (borrowing, issuing shares, etc), investing (buy assets and
invest in people), operating (using assets to earn profits)  performing these activities, firm
exposed to different levels of risk and opportunities
Multiple Step Income Statement under IFRS
1) Operating (rev, exp)
2) Non operating (gain/loss)
3) Income tax expense
4) Total : Income from Continuing Operation
5) Discontinued operation
6) Total: net income
7) Other comprehensive income
8) total: net income + OCI
Why do we need IS?
Evaluate past performance and profitability
Assist in predicting future performance (i.e., predictive value)
Assess potential risk or uncertainty in achieving future cash flows (e.g., recurring vs. non-
recurring)
Limitations:
Items that cannot be measured reliably are not reported in income statement
Financial reporting bias
GAAP
Amounts reported are affected by accounting methods used (e.g., straight-line vs. DDB)
Use of estimates in measuring income (e.g., bad debt expenses)
Different ways of measuring income (e.g., comprehensive income vs. net income vs.
income before discontinued operations)
Tim Hortons Starbucks
Rev 100 100
COGS 70 60
Operating Income 30 40
Gain 10 0
NI 40 40
Continuing Operation

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Chapter 4: Reporting Financial Performance
As Tim Horton’s earned 10$ from gains – it’s more risky to guess whether they will again attain
40$ net income in the next quarter. Starbucks income is more sustainable as their income is
coming from operating activities.
Quality of Earnings: how solid earnings numbers are
Characteristics of high quality earnings:
1. Nature of Content
1) Integrity of the information (i.e., representational faithfulness)
Unbiased and determined objectively
Represents economic reality
2) [ sustainability ] of the earnings
Reflects earnings from on-going operations
Closely correlated with cash flows from operations
2. Presentation
1) Does not disguise or mislead (transparent)
2) Earnings presentation is clear and concise
3) Easy to use and understandable
Earnings management reduces earnings quality!
Quality of earnings analysis often done to assess future earnings potential, sustainability of
income is important. Sustainability of income = whether company is able to continue to generate
or sustain these earnings in future given its current business model, industry and economy
Earnings management: process of targeting certain earnings level or desired earnings trend
and working backwards to determine what has to be done to ensure targets are met
Net income = revenue and gains less expenses and losses both from continuing and
discontinued operations
Comprehensive income = net income +/- other comprehensive income/loss
Concept of operating income not defined by GAAP – measure of regular income before any
irregular items such as gains/losses, discontinued operations and other comprehensive income
Other comprehensive income = made up of certain specific gains or losses including
unrealized gains and losses on certain securities  closed out to balance sheet account referred
to as accumulated other comprehensive income (equity account)
Haven’t actually sold the asset (unrealized gain or loss)  paper gain or loss
E.g. securities, foreign exchange
PCI closed to accumulated other comprehensive income (AOCI)
Single Step IS
Presents only two groupings before “Income before Discontinued Operations”:
1. [ revenues ] (includes gains)
2. [ expenses ] (includes losses)
[ income tax expense ] often reported as the last exp
expense line item in determining net income before discontinued operations
• Advantages:
1. Simple
2. Eliminates classification problems and reduce the likelihood of earnings
management
• Disadvantage:
1. Operating and non-operating activities reported together
Multiple Step IS
Revenue – COGS = Gross Profit
Key distinction from single-step: Operating and non-operating activities are separated
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Chapter 4: Reporting Financial Performance
• Advantages:
Highlighting regular and irregular activities allows for greater predictive value
and feedback value
Non-operating is incidental, hence less sustainable
Provides better detail to compare companies
Allows for ratio analysis used to assess performance (e.g., gross profit margin)
Discontinued operations – before net income after expenses
Continuing Operations
Continuing operations  operating section, non-operating section, income tax
oOperating section (ordinary activities)  net sales, COGS, selling, general and
administrative expenses (SG&A)
oNon-operating Section (incidental or peripheral)  other revenues and gains
(interest income, gains on sale of PP&E), other expenses and losses (e.g.
interest expense, impairment loss)
oIncome tax  income tax on income from continuing operating only
Intraperiod tax allocation used for following items: income from continuing operations,
discontinued operations and other comprehensive income
Presenting Expenses: Nature versus Function
Under IFRS, analysis of expenses must be presented based on either:
[ Nature ] type of expenses, i.e., what does the money pay for (e.g.,
purchase of materials, transportation costs, employee benefits, depreciation,
etc.)
[ Function ] refers to business function or activity, i.e., in which phase of
operation is the money spent (e.g., cost of sales, selling exp., admin. exp., etc.)
Choice should result in information that is more reliable and relevant
No similar requirement under PE GAAP
Discontinued Operations
Discontinued operations includes components that have been [ disposed of ] or are
[ held for sale ]
To qualify as discontinued operations, the discontinued business must be a component,
which has distinguishable cash flows, operations, and financial elements (e.g., asset,
liabilities)
PE GAAP: operating segment, reporting unit, subsidiary, asset group, or operations
without assets
IFRS: only major line of business or geographical area of operations. Or business
qualifying as held for sale
Held for sale: plan to sell it yet have not sold it yet
Distinction made between component’s results of operations an disposal of component’s assets
Discontinued operations are shown as net of tax
Depreciation is not recognized for held for sale assets
Remeasured at lower of carrying value and fair value net of cost to sell
Once asset is written down, subsequent gains can be recognized only up to amount of original
loss
Discontinued Operations – Presentation
On income statement, present separately for:
The component’s results of [ operations ]
Disposal of the component’s [ assets ]
Both reported net of taxes
On balance sheet:
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