RSM220- Chapter 4.docx

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University of Toronto St. George
Rotman Commerce
Dragan Stojanovic

REPORTING FINANCIAL PERFORMANCE [CHAPTER 4]  All business is based on the business model of getting $, investing it in resources, and then using these resources to generate profits o Model can be broken down into 3 types of activities:  Financing: obtaining $ funding, by borrowing, issuing shares, or retaining profits; also involve the repayment of debt or repurchase of shares  Investing: using the funding to buy assets and invest in ppl; these also include divestitures  Operating: using the assets and ppl to earn profits  Value creation is central in any business model- need to max shareholder value  Therefore FS should capture these fundamental business activities and communicate them properly o How info is communicated:  BS: aims to capture the financing and investing activities  IS: captures O and performance related activities  Cash flow statement: looks at interrelationship btwn activities INCOME STATEMENT  IS is the report that measures the success of a companys operations for a specific time period  Ppl use this report to determine profitability, investment value, and creditworthiness [Usefulness of the IS]  Investors and creditors use info in the IS to: 1. Evaluate the enterprises past performance and profitability 2. Provide a basis for predicting future performance 3. Help assess the risk or uncertainty of achieving future cash flows  In summary, provides feedback and predictive value [Limitations of the IS]  NI is not a point estimate, rather a range of possible values b/c of all the numerous assumptions due to accrual acc. Which needs est. for things like exps and asset values  IS has a mix of hard numbers (easily measured with reasonable level of certainty) and soft #s (more difficult to)  IS has following short comings: 1. Items that cannot be measured reliably are not reported in the IS i. Eg. Contingent gains as there is uncertainty about whether the gains will ever be realized 2. Income numbers are affected by the acc. Methods that are used i. Eg. diff dep. Methods 3. Income measurement involves the use of estimates i. Eg. write-offs, how useful an assets life is 4. Differing views of how to measure NI [Quality of Earnings]  When analyzing earnings info, there are 2 aspects that must be considered: 1. Content: which includes i. The integrity of the info- whether it reflects the underlying business fundamentals & ii. The sustainability of the earnings 2. Presentation- which means a clear concise manner that makes it easy to use and understand  The nature of the content and the way its presented are sometimes referred to as the quality of earnings  From accountants perspective, emphasis on ensuring the info is unbiased, reflects reality, and is transparent and understandable  From capital market perspective, those are important but additional focus on whether the earnings are sustainable  Higher quality earnings are more reliable, w/ a lower margin of potential misstatement and are more rep. of the underlying business and economic reality o These companies are attributed higher values by the markets  Attributes of high quality earnings: o Content  Unbiased and #s not manipulated and objectively determined  Reflect the economic reality  Reflect primarily the earnings generated from ongoing core business activities  Closely correlate with cash flows from operations  Based on sound business strategy and business model o Presentation  Transparent  Understandable  Earnings management: the process of targeting certain earnings levels (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 o Used to increase income in the current year by reducing income in future years o or can be used to decrease current in order to increase future income o have a negative effect on the quality of earnings FORMAT OF THE INCOME STATEMENT  Income can be further classified by customer, product line, nature, or function or by operating and non operating, continuing and discontinued and regular and irregular categories  Elements of FS: o Revenues: increases in economic resources either by:  Inflows  Enhancements of an entity’s assets  Settlements of L resulting from the entity’s ordinary activities o Expenses: decreases in economic resources either by  Outflows  Reductions of assets  Creation of L, resulting from an entity’s ordinary revenue generating activities o Gains: increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owners o Losses: decreases in equity form peripheral or incidental transactions …..except those that result from expenses or distributions to owners  OCI: made up on certain specific g/l that may be required to be presented separately on the IS (below NI) o Presented under IFRS but not under private entity GAAP and includes unrealized gains and losses on certain securities, foreign exchange g/l, and other g/l as defined by IFRS o Usually closed out to BS account that is referred to accum. OCI  Type of retained earnings account  Equity account on BS  Items required on IS for private and IFRS **pg 160** [SINGLE STEP IS]  Only 2 main groupings are used: revenues and expenses  Single step bc of the single subtraction neeed to arrive at net income before discontinued operations  Used in FR in smaller private companies [MULTIPLE STEP IS]  Separates operating transactions and non operating transactions and matches costs and expense with related revenues o Disclosing income from operations highlights the diff btwn regular and irregular or incidental activities [INTERMEDIATE COMPONENTS OF THE INCOME STATEMENT] When multiple step IS is used, some or all of these sections will be presented:  Continuing operations  Operating section: a report of the revenues and exps of the companys principle operations  Sales of revenue section : shows sales, discounts, allowances, returns  COGS:  Selling exps  Administrative or general exps o Non operating section: a report of rev and exps resulting from the company secondary activities; special g/l that are infrequent or unusual are normally reported here; break down into:  Other revenues and gains  Other expenses and losses o Income tax  Discontinued operations: material g/l resulting from the disposition of a part of the business (net of taxes)  Extraordinary items: atypical and infrequent material g/l beyond the control of management (net of taxes)  Other comprehensive income: other g/l that are not required by GAAP to be included in NI  includes all other changes in equity that do not relate to shareholder transactions (net of taxes)  Whether single step r multiple, irregular transactions such as discontinued operations, extraordinary item, and OCI need to be reported separately, following income from continuing operations [PRESENTATION OF EXPENSES: NATURE VS. FUNCTION]  Whether single or multiple, need to provide additional details about exps  IFRS requires an analysis of exps based on their nature or function: o Nature: eg.. dep, purchases of materials, transport costs… this method tends to be more straightforward since no allocation of costs is required btwn functions o Function: eg. cost of sales, distribution costs, admin costs…this requires more judgment since costs such as payroll and amort. Are allocated btwn functions [CONDENSED IS]  Includes the totals of exp groups in the IS and prepares supplementary schedules of exps to support the totals REPORTING IRREGULAR ITEMS  Either single or multiple can be used for FR purposes  2 important areas have specific guidelines though and those relate to what is included in income and how certain unusual or irregular items are reported  Income measurement follows a all-inclusive approach which indicates that most items, even irregular, are recorded in income; exceptions include o Error (of prior years) o Changes in accounting policies that are applied retrospectively  b/c these items relate to earnings that were already reported in prior period, not included in current income rather recorded as adjustments to RE  Some ppl use cu
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