Module 5, Part 1: Operating Income

1.Income statement categories -operating revenues -research and development expenses -restructuring expenses -discontinued operations -extraordinary items 2.Earnings per share Module 5, Part 1: Operating Income

Sales - COGS = Gross margin - Operating expenses = Income from operations + Other revenues and gains - Other expenses and losses = Income from continuing operations (IFCO) +/-Discontinued operations +/-Extraordinary items = Net income 1. Format of the I/S

Revenue Issues and SAB 101 - Channel stuffing - forced sales Barter transactions - swaps to puff up revenue Non-arm’s length transactions - related parties Pending approval - not revenue until approved Gross versus net revenues - gross (rev & expense) may misstate revenues for certain transactions Sales on consignment - while on consignment, not a sale (still belongs to the seller) Failure to deliver - ex: layaway, storage Nonrefundable fee - (ex: deposit) not recognized as revenue until the product is delivered Format of the I/S

Research and development expenses - Prior to SFAS 2 (1976), all R&D costs were capitalized, then amortized when products “came on line” and generated revenues (matching). SFAS 2 required companies to expense all costs relating to R&D, unless they related to fixed assets with multiple project uses (ex: buildings and some equipment). Rationale: too difficult to identify and match costs incurred to specific product revenues. Format of the I/S

Restructuring expenses - Include charges for employee severance and relocation. Include charges for write-down of assets retained in the business and write-off of assets sold or disposed of. Disclosure of components of restructuring charges now required by SEC. Companies historically used this account to “dump” a number of costs, including those not related to restructuring, in a “big bath” year. Format of the I/S

Now, more information on the “special” items below IFCO: discontinued operations extraordinary items Note that each of these items is presented “net of tax.” This is necessary because income tax expense has already been calculated on IFCO. Therefore, each level below IFCO must present the tax effect for that component. This is called “intraperiod” tax allocation - allocation of income tax expense to different parts of the income statement. A “partial” income statement is presented on the next slide (and assumes a 25% tax rate). Format of the I/S

Income from continuing operations $120 Income tax expense (30) Income from continuing operations - net of tax 90 Discontinued operations Income from operations of discontinued segment (less tax effect of $25) 75 Loss on disposal of discontinued segment (less tax effect of $10) (30) Extraordinary item Loss from flood damage (less tax effect of $9) (27) Net income $108 Partial Income Statement- Sample Company (assuming a 25% tax rate)

Note that “net of tax” can either be a gain/income offset by income tax expense, or a loss offset by an income tax reduction. In either case, the amount recognized is net, after the tax effect is subtracted out. In Sample Company, the calculations are based on a 25% income tax expense rate: Note that the pretax amounts = the net amount + tax Discontinued operations Pretax income of $100 x .25 = $25 expense Pretax loss of $40 x .25 = $10 expense reduction Extraordinary (pretax) loss of $36 x .25 = $9 expense reduction Calculations - Sample Company

Discontinued operations (DO) relate to the disposal of a segment of a company. Because the disposal means that the segment activity will be discontinued, separate disclosures are required so that investors could distinguish between ongoing activity and nonrecurring activity. A reportable segment may be a line of business or a distinct operating segment. Financial statement presentation includes any operating income or loss to the measurement date, as well as any gain or loss on the disposal of the assets. Estimated losses on future disposals are also required. Does notrequire a sales contract to reclassify to discontinued operations. IFCO can be manipulated with the declaration (and reclassification) of the discontinued segment. Format - Discontinued Operations

Extraordinary items are defined as those activities that are material in amount, unusual in nature, and infrequent in occurrence. To determine, consider the natural, political, and economic environment of the firm. Examples of EI include natural disasters, nationalization or expropriation of assets by a foreign government, and one-time major economic transactions. If unusual or infrequent, but not both, report in “other gains/losses”, as part of IFCO. Examples include material write-down of receivables, and loss from employee strike. Note to text, page 5-24, that “9/11 events not extraordinary” Format - Extraordinary Items

1. Loss in Florida from hurricane: 2. Loss from sale of a segment: 3. Loss from terrorist activity: 4. Material write-off of accounts receivable: 5.Normal write-off of accounts receivable: 6. Loss from flood (in a 500-year flood plain): I/S Classification - Class Problem

SFAS 128 simplified the presentation of earnings per share to two components: basic EPS diluted EPS Calculation of Basic EPS = Net Income - preferred dividends Average common shares outstanding Concept: to indicate how much each common shareholder “owns” with respect to earnings. Preferred dividends are deducted - if declared or if cumulative - because they are “owned” by to preferred shareholders. This is a calculation of “what is” - the numerator and denominator use actual shares outstanding and actual net income for the year. 2. Earnings Per Share (EPS)

Diluted earnings per share examines all the potentially dilutive securities that a company has issued, like convertible preferred stock, convertible bonds, and employee stock options. Although these securities have not been converted at year end, the calculation shows the effect that the shares could have on EPS. Calculation of Diluted EPS = Net Income - P.D + adjustment for dilutive shares Avg. CS outstanding + adjustment for dilutive shares Concept: to indicate how much each common shareholder would “own” with respect to earnings IF all dilutive securities had been exercised at the beginning of the year. Earnings Per Share (EPS)

Diluted EPS is a “what if” calculation - the numerator and denominator are adjusted for potential effects of dilutive securities as of the securities had been converted to common stock at the beginning of the current year: convertible PS: eliminate preferred dividend (would not exist if converted) increase shares outstanding (would be larger if converted) convertible bonds: eliminate interest expense (would not exist if converted) increase shares outstanding (would be larger if converted) stock options: no numerator effect (generally speaking) increase shares outstanding (note that it is not a 1 for 1 conversion). If any of these potentially dilutive securities exist, the company is said to have a complex capital structure. Earnings Per Share (EPS)

Class problem: Bush Company reported net income of $30,000 in 2000. The company had 60,000 shares of common stock outstanding for all of 2000. Bush also had 5,000 shares of convertible preferred stock outstanding for all of 2000. During 2000, the company declared a $4,000 cash dividend to preferred shareholders. Each share of preferred stock is convertible to 4 shares of common stock. 1.Calculate basic EPS: $30,000 - 4,000_ = $0.43 per share 60,000 (Note that the convertibility component is ignored for basic EPS.) Earnings Per Share (EPS)

2. Calculate diluted EPS: $30,000 - 0 _ = $0.38 per share 60,000 + (5,000 x 4) Note that the convertibility component is assumed to have been exercised for diluted EPS. If the PS was converted to CS at the beginning of the year, there would have been NO preferred dividend, and there would have been 20,000 additional shares of common stock outstanding all year. The effects for convertible bonds and employee stock options are similar for diluted EPS. Earnings Per Share (EPS)

Separate EPS disclosure for: Net income from continuing operations (after tax) Disposals of business segments Extraordinary items Calculation Separate dollar amount (from above categories) divided by number of common shares outstanding If diluted EPS exists, the company should also calculate diluted EPS for each level of presentation. If diluted EPS is antidilutive (the calculation is actually higher than basic EPS), the company does not have to present diluted EPS. EPS Disclosure

Basic Earnings Per Share: Income from continuing operations $0.90 Discontinued operations Income from operations of segment 0.75 Loss on disposal (0.30) Extraordinary loss (0.27) Net income $1.08 EPS Disclosure - Sample Co.(Based on 100,000 shares outstanding.)

The numerator can be manipulated by a number of earning management techniques. The denominator can be manipulated by stock buybacks (treasury stock). The “what-if” presentation of diluted EPS is a fictitious number - it can never actually happen. The potentially dilutive securities have not been converted at year end, and they can never have claims to the current year’s income. The only benefit of diluted EPS is that it can indicate the magnitude of the maximum potential dilution for the future. Problems with EPS

Module 5, Part 1: Operating Income