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Chapter 4

RSM220H1 Chapter Notes - Chapter 4: Cash Flow Statement, Retained Earnings, Earnings Management


Department
Rotman Commerce
Course Code
RSM220H1
Professor
Dragan Stojanovic
Chapter
4

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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
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
INCOME STATEMENT

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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

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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
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