Intermediate Accounting Chapter 4 Rockhurst

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Income statment

Back 1

Summarizes the profit generating activities that occurred during a particular reporting period. Many investors and creditors perceive it as the statement most useful for predicting future profitability.

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Statement of Cash flows

Back 2

Provide info aboutthe cash receiptsand disbursements of an enterprise that occurred during a period. Provides valuable info about the operating, investing, and financing activities of a co. during that period.

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Income from continuing operations

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revenues, expenses, gains, and losses excluding those related to discontinued operations and extraordinary items.

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Income tax expense reporting

Back 4

Because of the importance and size of income tax expense, it is always reported as a separate expensein corporate income statements.

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Taxable income

Back 5

All revenues, expenses, gains, and losses as measured according to the regulations of the appropriate tax authority.

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Operating income

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includes revenues and expenses directly related to the primary revenue generating activities of the company. Example mfg co in cludes sales revenue from selling the product itmanufactures as well as all expenses related to this activity.

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Nonoperating income

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relates to peripheral or incidental activities of the company. For mfg co they would include interest and dividend revenue, gains andlosses from selling investments, and interest expense in nonoperating income.

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Single step income statement

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First lists all revenues and gains in income from cont operations. then expenses and losses are grouped, subtotaled, and subtracted--in a single step-- from revenues and gains to derive income from continuing ops. Operating and nonoperating items are not separately classified.

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Multiple step format for income statement

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reports a series of intermediate subtotals such as gross profit, operating income, and income before taxes.

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Earnings quality

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refers to the ability of reported earnings (income) to predict a co's future earnings. To enhance predictive value, analysts try to separate a co's transitory earnings from its permanent earnings. Transitory earnings effects result from transactions or events not likely to occur again in the foreseeable future, or that are likely to have a different impact on earnings in the future.

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manipulation and income smoothing

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within GAAP managers have the power to a limited degree, to manipulate reported co income. Some companies 'bank' earnings by understating them in particularly good years and use the banked profits to polish results in bad years. Many believe manipulating income reduces earnings quality because it can mask permanent earnings.

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How do managers manipulate income?

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2 major methods are:
1. Income shifting
2. Income statement classification

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Income shifting

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Achieved by accelerating or delaying the recognition of revenues or expenses.

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Income statement classification

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The most common income statement classification manipulation involves the inclusion of recurring operating expenses in "special charge" categories such as restructuring costs.

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Restructuring costs

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a program that is planned by management, and materially changes either the scope of a business undertaken by an entity, or the manner in which that business is conducted.

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Accounting for restructuring costs

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Recognized in the period the exit or disposal cost obligation actually is incurred. GAAP also establishes that fair value is the objective for initial measurement of the liability and that a liability's fair value often will be measured by determining the present value of future estimated cash flows. When an estimate is changed the co should record the effect of the change in th period in which the estimate is changed rather than by restating the prior years' statements to correct the estimate.

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How to misuse restructuring costs

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An analyst must interpret restructuring charges in light of a company's past history. In general, the more frequently these sorts of unusual charges occur the more appropriate that the analyst include them in the company's permanent earnings stream.

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Items included in operating expenses include

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Impairment of good will and write down on inventory

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Pro forma earnings

Back 19

voluntary number provided when they announce quartely or annual earnings. Pro forma numbers are controversial because determining which items to exclude is at the discretion of management. Management could mislead investors. Sarbanes Oxley addressed it. It stated that if they are included, the company must also provide a reconciliation with earnings determined according to GAAP.

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2 types of separately reported items

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1. discontinued operations.
2. Extraordinary items

Front 21

Reporting nonopertaing items

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The objective is to separately report all of the income effects of these items. That's why we include the income tax effect of each item in this separate presentation rather than reporting them as part of income tax expense.

Front 22

Intraperiod tax allocation

Back 22

Associates income tax expense (or benefit in the case of a loss) with each major component of income that causes it. Income tax is allocated to income from continuing ops and then to each seperateyl reported item. It is not an issue of measurement but an issue of presentation. Each of the items are presented net of their tax ecffect. No indicidual items included in the computation of income from continuing operations are reported net of tax.

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What constitutes an operation?

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An ooeration is a component of an entity whose operations and cash flows can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity.

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Operating segment

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An operating segment is a part of an enterprise: that may earn revenues and incur expenses, whose operating results are regularly reviewed to make decisions about resources to be allocated to the segment and assess its performance, and for which discrete financial info is avail.

Front 25

Reporting discontinued operations

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By definition, the income or loss stream from disc ops will no longer continue. The revenues, expenses, gains, losses, and income taxes related to a discontinued operation are removed from continuing operations and reported separately for all years presented.

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When the discontinued ops component has been sold

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It will include 2 elements, 1. operating income or loss (revenues, expenses, gains, and losses) of the component from the beginning of the reporting period to the disposal date. and 2. Gain or loss on disposal of the component's assets.

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When the discontinued ops component is considered held for sale

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The income effects of discontinued operations are still reported, however the components of reported amount are modified as follows:
1. Operating income/ loss of the period from the beginning of the reporting period to the end of the reporting period.
2. An "impairment loss" if the carrying value (book value) of the assets ofthe component is more than fair value minus cost to sell.

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Extraordinary items

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Material events and transactions that are both unusual in nature and infrequent in occurance. There is a considerable degree of subjectivity used in determination of this. Unexpected eventsthat are not considered extraordinary items such as the lossof a majorcustomer or thedeath of a president. They both arise from normal operating risk. Not considered extraordinary are things such as strikes, and adjustments of accruals on long term contracts. What is extraordinary for one co may not be extraordinary for another. Example hurricane in MO extraordinary, not extraordinary in florida.

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Unusual or infrequent

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If te income effectof an event is material and the event is either unusual OR infrequent, but not both, the income should be included in continuing operations but reported as a separate income statement component. Restructuring costs, impairment of goodwill, and long lived assets included in that co's continuing operations are examples of this type of event. they may be unuals or infrequent but they could happen again in the foreseeablefuture.

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Accounting changes 3 types:

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1. Change in accounting principle
2. Change in estimate
3. Change in reporting entity

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Change in accounting principle

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Involves a change from one acceptable reporting method to another. Such as from FIFO to LIFO or from DDB to straight line. Can be voluntary or mandatory

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Voluntary changes in accounting principles

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Changes cause inconsistency and lack of comparability. Because of this GAAP requires that voluntary acconting changes are reported retrospectively. WE recast prior years statements when we report those statements again, we revise the balance of each account affected to make those statements appear as if the newly adopted accounting method had been applied all along. Then we make a journal entry to adjust all account balances affected to what those amounts would have been, An adjustment is made to beginning balance of retained earnings for the earliest period in the comparative statement of shareholder equity to account for the cumulative income effect of changing to the new principle in periods prior to those reported.

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Mandated changes in accounting principle

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When a new FASB standard mandates a change in accounting principle, the board often allows companies to choose among multiple ways of accounting for the changes. One approach generally allowed is to account for the change retrospectively, exactly as we account for the voluntary change in acct. principle. A second method is to allow companies to report the cumulative effect on the income of previous years from having used the old method rather than the new method in the income statement of the year of change as seperately reported item below extraordinary item.

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Change in depreciation, amortization, or depletion

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A change in one of these is considered to be a change in accounting estimate that is achieved by a change in accounting principle. WE account for these changes prospectively, exactly as we would any other change in estimate.

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Change in accounting estimate

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When an estimate is modified as new info comes to light, accounting for the change in accounting estimate is quite straightforward, we do not revise prior year statements, we merely incorporate the new estimate in any related accounting determination from that point on, that is prospectively. When a co makes a change in an estimate the affects several future periods, such as revising the estimate of an asset's useful life, the co reports in a disclosure note the effect of that change on the current year's income before extraordinary items, net income and earnings per share.

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Change in reporting entity

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Involves preparation of financial statements for an accounting entity other than the entity that existed in the previous period. The more frequent the change in entity occurs when one co acquires another one. The financial statements of the acquirer include the acquiree as of the date of acquisition, and the acquirer's prior period financial statements that are presented for comparative purposes are not restated,

Front 37

Corrections of accounting errors

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Most errors are discovered the same year as they are made. These are simple, the original erroneous journal entry is reversed and the appropriate entry is recorded. If an error is discovered in a year subsequent to the year the error is made, accounting treatment depends on whether or not the error is material with respect to its effect on the financial statements.

Front 38

Prior period adjustments

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The correction of material errors is considered a prior period adjustment. Refers to an addition or reduction to beg retained earnings balance in a statement of shareholder's equity. Explicitly reporting a prior period adjustment on the statement of shareholder's equivy avoids confusion. in addition to reporting the prior period adjustment to R/E, previous years financial statements that are incorrect as a result of the error are retrospectively restated to reflect the correction. Also, a disclosure note communicates the impact of the error on income.

Front 39

Earnings per share

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Shows the amount of income earned by a company expressed on a per share basis.

Front 40

Diluted EPS

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If there are certain potentially dilutive securities, diluted EPS are generally reported on the face of the income statement.

Front 41

Basic EPS calculations

Back 41

Computed by dividing income available to common shareholders (net income less any preferred stock dividends) by the weighted average number of common shares outstanding (weighted by time outstanding) for the period.

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Diluted EPS reflects what?

Back 42

The potential dilution that could occur for companies that have certain securities outstanding that are convertible into common shares or stock options that could create additional common shares if the options were exercised.

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Other comprehensive income

Back 43

The calculation of net income excludes certain types of gains and losses that are included in comprehensive income. Gains and losses resulting from adjusting those investments to fair values might not be included in net income but instead reported as comp income

Front 44

Accumulated other comp income

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IN addition to reporting OCI that occurs in current reporting period, we must also report these amounts on a cumulative basis in the balance sheet. We report OCI as it occurs in the current reporting period and also report accum other comp income in the balance sheet.

Front 45

Statement of cash flows purpose

Back 45

Provide info about the cash receipts and cash disbursements of an enterprise that occurred during a period. It is a change statement, summarizing the transactions that caused cash to change during a reporting period.

Front 46

Usefulness of cash flow statement

Back 46

Over short periods of time, operating cash flows may not be indicative of the co's long run cash generating ability, and that accrual based net income provides a more accurate prediction of future operating cash flow. A co must pay its debts in cash and not with income. So it's imp.

Front 47

The statement of cash flows classifies all transactions affecting cash into one of three categories:

Back 47

1. Operating activities
2. investing activities
3. Financing activities

Front 48

Operating activities

Back 48

Cash inflows include cash received from:
1. Customers from the sale of goods or services.
2. Interest and dividends from investments.

Cash outflows include cash paid for:
1. The purchase of inventory
2. Salaries, wages, and other operating expenses
3. Interest on debt
4. Income taxes
The difference between inflows and outflows is called net cash flows from operating activities

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Indirect method

Back 49

WE arrive at net cash flow from operating activites indirectly by statrting with net income and working backwards to convert that amount to a ccash basis. 2 types of adjustments to net income are needed. 1st components of net income that do not affect cash are reversed. That means that noncash revenues and gains are subtracted, while noncash expenses and losses are added. Second, we make adjustments for changes in operating assets and liabilities during the period that indicate that amounts included as components of net income are not teh same as cash flows for those components.

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Investing activites cash flows

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INclude inflows and outflows of cash related to the acquisition and disposition of long lived assets used in the operations of the business and investment assets.
Cash outflows from investing include:
1. purchase of long lived assets used in the business.
2. Purchase of investment securities like stocks and bonds of other entities (other than those classified as cash equivelents, and trading securities)
3. Loans to other entities.

Cash inflows from investing:
1. Sale of long lived assets.
2. Sale of investment securities
3. Collection of a nontrade receivable (excluding the collection of interest, which is an operating activity).

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Financing activities

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Relate to the external financing of the company.
Cash inflows occur when:
1. Owners when shares are sold to them
2. Creditors when cash is borrowed through notes, loans, mortgages, and bonds.

Cash outflows include cash pd to:
1. Owners in the form of dividends or other distributions.
2. Owners for the reacquisition of shares previously sold.
3. Creditors as repayment of the principal amounts of debt (excluding trade payables that relate to operating activities).