Lecture 10 - Income and Equity Statements

Income and Equity Statements

Quality of Earnings

Everyone looks at the bottom line.

If everyone has the same bottom line (net income), are they equivalent - comparable quality of earnings?

All-inclusive concept requires extraordinary items to be included. However, this can pump up earnings artificially. To the extent that income is attributable to continued operating income, it shows a higher quality of earnings.
Another example: Income from discontinued operations.
See page 613 for examples.

Income Taxes

Depreciation may be different between financial accounting and tax accounting. (Straight line for FA and accelerated for TA)

To resolve this problem, use interperiod income tax allocation. See example in class slides.

To adjust in the first year...
Dr. Provision for taxes 200
--- Cr. Tax Liability 120
--- Cr. Deferred Taxes 80

In the following year...
Dr. Provision for Income Tax 200
Dr. Deferred Taxes 80 (eliminate the previous years' credit)
--- Cr. Tax Liability 280

Discontinued Operations

Notify analysts that some of income is from operations that are no longer going on.
Report the Income from these ops and the gain/loss on disposition of assets.

Ordinary income is the income from continuing operations.

Separate the reporting of the income tax expense from ordinary and taxes from discontinued ops. This is intraperiod income tax allocation.

See example in class slides (pg. 9-15)

Extraordinary Items

Separately disclosed so the reader knows it's not likely to continue. Exact definition is not clear. Standard definition is that it's "extraordinary" if it's "the result of an unusual event and infrequent."

Presented just like discontinued operations and net of tax.

All such income is presented before net income.

Earnings Per Share

Was formerly a very difficult topic on the CPA exam.

It's for common shares only. Subtract out those earnings that are attributable to preferred shares - dividends.

Compute for each component:
Operating income per share
Extraordinary items per share
Discon
Net income

Must use a weighted average of shares outstanding throughout the year, not the simplified average that we use with some of the ratios.

Options or other securities that could be converted to common stock are “dilutive” and result in a lower earnings per share. Do an additional calculation based on an assumption that those securities get converted to get a diluted eps. Converting bonds will increase the denominator (# of shares outstanding) but may also increase the numerator also because there will be less interest to pay on those bonds.

Statement of Stockholders’ Equity

The details of this statement are not material for the exam. But there is usually a statement of stockholders’ equity, not just retained earning.

This statement will have information on common stock, preferred stock and other capital accounts in addition to retained earnings.

Unrealized gain/loss on available for sale securities and foreign currency conversion adjustments were once reported in the statement of shareholders’ equity. FASB then required them to appear on the balance sheet and to report “comprehensive income” Some companies start with net income and add items to get to comprehensive income. Apple embeds it in the calculation of net income.

Stock Dividend

Issuance of addition stock as a dividend. These have the advantage that they are not taxable to the shareholders and if they need the cash, they can always sell it.

Note: We’re not covering entries on declaration, record and distribution dates.

Stock Split

Cancels old shares and issues 2x new shares. Why? Makes the shares more affordable for investors.

There are also occasionally reverse splits. Why? Because shares could be delisted if the share price is too low.

No entries are required for stock splits.

Book Value (or Book Value per Share)

Equity attributable to common shares of stock
Equity attributable to

Ex:
Assets 2,000,000
Liabilities 1,000,000
Owner’s Equity 1,000,000

1,000,000 shares of common stock outstanding

Book value is 1,000,000
Book value per share is $1.00

Ex 2:
Say there was 200,000 common share and 800,000 preferred
Book value per share is $0.80

Ex 3: If preferred stock was callable at 102, reduce the
1,000,000 – 1.02(200,000) / 1,000,000

How valuable is this number? It doesn’t mean that much, it’s hard to interpret. Nonetheless, people give it attention “we paid 5x book value”.

Cash Flow Statement

Required in order to give audited statement. Hard to derive information from other statements. Possible, but difficult.

Focus is on the change in cash balances. If you just look at the bottom line, it’ll be hard to interpret what impacted the cash flow. The source is more important than the amount.

Explains the net increase/decrease in cash by explaining the cash flow from:
Operating activities
Investing activities – of the firm itself. Firm sold some assets to generate cash
Financing activities – raising cash from debt or equity

Some things that are done directly are prepared on separate schedule (ex: issuing shares to purchase a building, if done in one transaction.)

Two methods: direct and indirect. Book only covers indirect (formerly covered both), and we will only cover it also.

Indirect method: Starts with net income and adjusts it to convert to cash flows from operations.

How do we get there?

We assume that net income is a first approximation of cash flow. But some things are not and we need to adjust for those.

On the revenue side, Ex: accounts receivable. It increases the AR asset account but doesn’t affect the Cash account.

So we subtract out any increases in current assets.

We must also subtract out any decreases in current liabilities

On the expense side,
We must add in the increases in current liabilities and…
Add back in the decreases in current assets

How do we handle depreciation and other non-cash expenses? They are expenses that do not involve real cash flows. So add it back in to the net income.

How do we handle gains and losses?
Typically, the entry for the sale of an asset is…
Dr. Cash
Dr. Accum Depr
Cr. Asset
Cr. Gain

Gain shows up in the income statement. But we don’t want that gain in the cash flow. We’re interested in the Cash amount. So deduct any gains and add in any losses.

Some ppl talk about the “cash flow generated from depreciation”. Although it’s a positive number that is added to net income, it’s really not accurate to call it a cash flow. It’s an adjustment.

Cash flow from Investing Activities and Sale of Plant Assets

See examples in class slides.