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Chapter 4

RSM220H1 Chapter Notes - Chapter 4: Income Statement, Efficient-Market Hypothesis, Risk Management

Rotman Commerce
Course Code
Dragan Stojanovic

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Chapter 4: Reporting Financial Performance
Lecture 5 (page 181-214)
Income statement: measures success of a company’s operations for specific period of time
Business Models and Industries
Business model: consists of getting cash, investing resources, then using resources to generate profit
Model can be broken down into 3 types of activities:
oFinancing: obtaining cash funding by borrowing, or equity, involves repayments of debt/repurchase of
oInvesting: funding to buy assets and invest in people, includes divestitures
oOperating: using assets to earn profits
Risk management: area of study involved in identifying, deciding if and how to manage and monitor risks
Techniques to manage risks i.e. educating employees, insurance, safety equipment  costs money
Risk/return tradeoff: market demands a greater return when there is a greater risk
Value creation: act of finding optimal balance between managing risks and taking the right opportunities such that
the firm’s net assets and potential are maximized
Low cost/high volume strategy: lower prices attract higher customers and get higher volume of sales (walmart
uses this)
Cost differentiation strategy: attract higher prices because it sells more unique and higher end products
Communicating Information about Performance
Use income statement to:
oEvaluate enterprises past performance and profitability
oProvide a basis for predicting future performance
oHelp assess the risk of not achieving future net cash inflows
Qualities of Earnings/Information
Income statement mix of hard and soft numbers
Hard numbers: easily measured with reasonable level of certainty i.e. cash sales
Soft numbers: difficult to measure, significant measurement uncertainty
Shortcomings of income statement:
oItems not reliably measured are not reported – if material should be disclosed in notes
oIncome numbers affected by accounting methods used i.e. using straight-line or double declining
oIncome measurement involves the use of estimates i.e. estimating useful life of asset
oFinancial reporting bias
oGAAP may not properly be represented
Quality of earnings: how solid the earning numbers are; used by analysts and investors to assess how well the
reported income reflects the underlying business and future potential
Two aspects of quality of earnings:
1) Content
- Integrity of information  unbiased and reflects underlying business fundamentals
- Sustainability of earnings  can company continue to generate or sustain earnings in future given
business model, industry and economy
2) Presentation
- Earnings presented in clear concise manner that makes info easy to use and understandable
Statements reflect nature and source of income on a historical basis, does not make promises about future
Business can accurately and appropriately reflect in GAAP financial statements, but quality of earnings can be
low because earnings are felt unsustainable
High quality earnings provide higher quality info and have a lower margin of potential misstatement; represent
underlying business and economic reality
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Earnings management: process of targeting certain earning levels (whether current or future) or desired earnings
trends and then working backwards to determine what has to be done to ensure these targets are met; involves
selection of accounting and other company policies, use of estimates, execution of transaction
Earnings management used to decrease current earnings to increase future income or vice versa
Reserves established by using aggressive assumptions to estimate items i.e. sales returns, loan losses etc; can be
reduced in future to increase income
Earnings management has negative effect on quality of earnings, as long as there is full disclosure, an efficient
market should see through these attempts to mask underlying economic reality
The Statement of Income and the Statement of Comprehensive Income
Comprehensive income/all-inclusive approach: net income ± other comprehensive income/loss
Net income: represents revenues and gains less expenses and losses from both continuing and discontinued
Operating income: generally seen to be ongoing revenues less expenses, not defined by GAAP
Current operating performance approach: argue that most useful income measures are the ones that reflect regular
and recurring revenue and expense elements that is normalized, sustainable earnings
People who like current operating approach argue that including one-time write offs reduces income measure’s
basic predictive value
Operating income misses important info about firm’s importance, as losses or gains (1 time or not) speak to the
volatility of past earnings, they have feed-back value
Accumulated Other Comprehensive Income: acts as retained earnings, equity account
Discontinued Operations
i.e. components of an enterprise that have been disposed of or are classified as held for sale
Discontinue to downsize, improve operating results, focus on core operations, generate cash flows
Separate Component
In order to have a separate presentation on income statement, the discontinued business must be a component of
an entity where the operations, cash flows, and financial elements are clearly distinguishable from the rest of the
A component consists of a unit of operation i.e. hotel or apartment building rented out or major subsidiary or
geographical area
Disposal of an asset constitutes a disposal of a component when the key elements are the asset or group of assets
generates its own net cash flows and is operationally distinct (operates as separate unit)
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