CHAPTERS

1. CHAPTERS 15 &18 FINANCIAL REPORTING: Part 1: The Income Statement

2. Additional sections follow belowoperating income; they are for reporting material items not typical of regular operations. These non-typical times include: Non Operating Revenues and Expenses Discontinued operations Extraordinary items Each item should be carefully explained in notes to the financial statements, and the income statement should report the income tax expense or savings applicable to each item. INCOME STATEMENTSAdditional Sections

3. Any item that does not have anything to do with the regular business activities of the business. Examples include: Minor “other” revenues Interest expense Gains and losses on the disposal of assets INCOME STATEMENTS1. Non Operating Revenues and Expenses

4. Discontinued operationsrefers to the disposal of a significant segment of a business, such as the elimination of an entire activity or of a major class of customers. Income (loss) from discontinued operations consists of Income (loss) from operations, and Gain (loss) on disposal of the segment. INCOME STATEMENTS2. Discontinued Operations

5. Extraordinary itemsare events and transactions that meet three conditions: Infrequent Non-typical Not subject to management decision INCOME STATEMENTS3. Extraordinary Items

6. INCOME STATEMENTS Extraordinary vs. Non-Extraordinary Extraordinary Items 1. Effects of major casualties (acts of God) if rare in the area 2. Expropriation (takeover) of property by a government 3. Effects of a newly enacted law or regulation, such as a condemnation action Ordinary Items (But not Operating Items) 1. Effects of major casualties (acts of God) if frequent in the area 2. Write down of inventories or write off of receivables 3. Losses attributable to labour disputes 4. Gains or losses from sale of capital assets

7. INCOME STATEMENTSPresentation – From Operating Income Onwards • Operating Income $504,850 Non – Operating Items Other Revenues and Gains $2,900 Interest Revenue 8,000 Gain on sale of Equipment Total non-operating revenues and gains 10,900 Other Expenses and Losses $(3,750) Interest Expense (5,000) Casualty Loss from Vandalism Total non-operating expenses and losses (8,750) Total Income before Taxes $507,000 (202,800) Less: Income Taxes (assume 40% tax rate) Income from Continuing Operations $304,200 Discontinued Operations • Income from real estate division, net of tax expense $5,000 –$2,000(40%) is… $3,000 • Loss from sale of real estate division, net of tax savings (30,000) $50,000 –$20,000(40%) is… • Income (Loss) on Discontinued Operations (27,000) Income before Extraordinary Items 277,200 Expropriation of Property,net of tax savings (60,000) – 24,000(40%) is… (36,000) Net Income 241,200

8. INCOME STATEMENTSEarnings Per Share - Additional Disclosures HWA ENERGY, INC. Net income $301,000 Earnings per share $5.60 (2.10) 3.50 (.49) $3.01 Income from continuing operations Loss from discontinued operations Income before extraordinary item Extraordinary loss Net income When the income statement contains any non-typical item, EPS should be disclosed for each component.

9. Prior Period Adjustments • Whenever a change in an accounting policy or procedure is made (e.g. FIFO to LIFO), the effects on Net Income (net of tax) for all prior years is charged directly to Capital. • Capital Account (for sole proprietorships) • Retained Earnings (for corporations)

10. Prior Period Adjustments • A business with a 6 year old machine, and a 40% tax rate, changes it’s amortization method from straight line to declining balance. This produces $40,000 of additional expense up to Jan. 1 of this year. It is shown in the Equity section as follows Begin. Balance Jan. 1 as previously reported $124,000 Change in accounting policy net of $16,000 (24,000) in tax Retained Earnings Jan. 1 as adjusted $100,000 Add: Net Income $80,000 Less: Drawings/Dividends (20,000) Change in Equity for the year 60,000 Ending Balance, Dec. 31 $160,000

11. Do Problems: P15-6A P15-7A

12. Earnings per share (EPS)indicates the net income earned by each common share. Companies report earnings per share on the income statement The formula to calculate earnings per share when there has been no change in shares during the year is as follows: EARNINGS PER SHARE Net Income – Preferred Dividends Number of Common Shares Earnings per Share 

13. PRICE - EARNINGS RATIO Market price per share Earnings per share Price-Earnings Ratio  The price-earnings (P/E) ratio helps investors determine whether the shares are a good investment in relation to earnings. It is a per share calculation, calculated by dividing the market price of the shares by its earnings per share. A high P/E ratio can be one indicator that investors believe the company has future growth potential.

14. FINANCIAL REPORTING: Part 2: The Statement of Changes in Financial Position, or The Cash Flow Statement, or the Statement of Cash Flows, or that statement that Boulton never taught us way back in grade 11 with eighteen versions of a really, really long damn name that I can’t even be bothered to remember so I’ll just call it whatever comes into my head. CHAPTERS 15 &18

15. To provide information about cash receipts and cash paymentsduring the period Recall that accounting numbers are NOT cash based, they’re accrual based. The Cash Flow Statement reconciles these two values (i.e. it turns accrual Net Income into real Cash Flow). CASH FLOW STATEMENT Purpose Note: we are only going to learn the “indirect method.”

16. CASH FLOW STATEMENT Purpose Achtungen!

17. The cash flow statement is prepared differently from the other financial statements; it is not prepared from the worksheet/trial balance. Instead, you require the following information: 1.Comparative balance sheets (2 years) 2. Current income statement 3. Any additional information CASH FLOW STATEMENT What You Need

18. Know that there are three sections to the Statement: Operating activities Investing activities Financing activities CASH FLOW STATEMENT What You Need

19. RULE OF THUMB: If it was subtracted from profit but didn’t use cash, add it back If it was added to profit but didn’t generate cash, deduct it. If it doesn’t affect cash, don’t put it in the Cash Flow Statement! CASH FLOW STATEMENT The Process

20. Step 1: Go through the comparative balance sheets and determine the value of all differences Step 2: Start the Cash Flow Statement. Begin by listing Net Income. You’ll now convert this number to Net Change in Cash by doing the following: Step 3: Place the differences (from Step 1) into the appropriate section (be sure to list properly as an increase/decrease to cash) Step 4: Complete the statement by taking any additional information into account. This may require adjustments to Step 3. CASH FLOW STATEMENTThe Process

21. Start with your NET INCOME figure. All changes will be made to this figure. You’ll be converting it from an ACCRUAL number, into a CASH number. We do it this way so we have at least something to start with, otherwise we’d have to start at zero and adjust for every transaction for the year. CASH FLOW STATEMENTStep 2.

22. Operating activities include: Regular business operations, i.e. the cash effects of transactions that create revenues and expenses Generally: CASH FLOW STATEMENT Step 3: Operating Activities From the Balance Sheet From the Income Statement Current Assets: Revenue & Expense: An increase is a USE of cash, deduct it. Since we start with the Net Income, revenues and expenses are already accounted for. Only non-cash revenues and costs are a concern. Examples include: Why? Example: Accounts Receivable Current Liabilities: An increase is a SOURCE of cash, add it back. Example: Accounts Payable Why? Amortization Increase: add back Losses Increase: add back Gains Increase: deduct

23. Investing activities include: Purchasing and disposing of investments and capital (L-T) assets using cash, and Lending others money and collecting on those loans Generally: CASH FLOW STATEMENTStep 3: Investing Activities From the Income Statement From the Balance Sheet Capital Assets Generally, items here are not a concern Additional information should tell you if you need to worry about Dividends Received for significant ownership (>20%), since they’re not recorded as revenue they must be added. Interest Revenue on money lent is already in Net Income. An increase in investments or other long-term assets is a USE of cash, deduct it.

24. Financing activities include: Borrowing money from others and repaying the amounts borrowed, and Obtaining cash from owners/shareholders and paying them drawings/dividends Generally: CASH FLOW STATEMENTStep 3: Financing Activities From the Income Statement From the Balance Sheet Long-Term Debt and Equity Generally, items here are not a concern. An increase in debt or equity is a SOURCE of cash, add it. Dividends are a USE of cash, deduct. Note: if you’ve issued bonds or shares, you’ve probably used the funds to buy assets, so you’ll have entries under Investing Activities. Note: Interest paid on bonds is an operating item and is already incorporated in the Net Income figure that you start with.

25. Remember: You must take additional information into account (provided in question) Why? Example: value of Land may change by $10,000 over the course of the year However, this may be due to a purchase of $20,000 of new land, and a sale of $10,000 of old land. Both activities need to be shown, not just the net change of $10,000 CASH FLOW STATEMENTStep 4: Additional Information

26. COMPUTER SERVICES COMPANY Cash Flow Statement — Indirect Method For the Year Ended December 31, 2002 CASH FLOW STATEMENT What’s It Look Like?

27. A Cash Flow Statement tells you many things You need to learn how to spot red flags and understand their significance CASH FLOW STATEMENT What’s It Mean?

28. Meaning of Significant USE of Cash in: Accounts Receivable Giving credit to risky customers – bad debt Not collecting quickly enough – week credit policies Poor management of A/R department Incompetence in A/R department Inventory & other Short-Term Assets Purchasing too much inventory Could be poor sales, bad forecasts, management incompetence May be a result of lax controls in purchasing, or a sudden change in demand Building up inventory in anticipation of business expansion CASH FLOW STATEMENT What’s It Mean? – The Operating Section

29. Meaning of Significant USE of Cash in: Accounts Payable You’re paying of debt too quickly Not taking advantage of credit granted Not having a good credit rating and not being granted credit Poor management in A/P department CASH FLOW STATEMENTWhat’s It Mean? – The Operating Section

30. Meaning of Significant USE of Cash in: Capital Assets May signal a business restructuring May indicate that many assets are old and need to be replaced May signal an up-coming change in product lines or business focus May be an indication of over zealous ambitions: buying far too expensive equipment, unnecessary purchases, etc. Investments If investments rise, may be an indication that the company has very healthy cash flows, and can afford to invest in stocks/bonds Increase in equity investments may indicate an intention of a takeover CASH FLOW STATEMENTWhat’s It Mean? – The Investing Section

31. Meaning of Significant USE of Cash in: Debt & Equity Looking to purchase new assets or a new business Indication of intention to expand in some way Indication of a need to refinance debt (current loans have interest that is too high)…(look to see what’s going on in the investing section) May be showing that company is short on funds and needs loans to keep itself a float (look at other areas of statement for clues) Dividends May be paying out too much in dividends, drain on cash Could be a result of poor decisions, demands/expectations of shareholders CASH FLOW STATEMENTWhat’s It Mean? – The Financing Section

32. Liquidity Cash current debt coverage ratio Profitability Cash return on sales ratio Cash flow per share Solvency Cash total debt coverage These ratios are cash-based instead of accrual-based CASH FLOW STATEMENT What’s It Mean?

33. Cash current debt coverageindicates the amount of cash to pay off current debt that is generated from operating activities. The ratio provides a better picture of liquidity than using the current ratio because it uses cash provided by operating activities rather than the year-end asset balance. CASH CURRENT DEBT COVERAGE Cash Provided by Operating Activities Cash Current Debt Coverage Average Current Liabilities 

34. Cash return on salesindicates how quickly sales are turned into cash. The company is efficient at turning sales into cash when its cash return on sales is greater than its accrual-based counterpart, the profit margin. CASH RETURN ON SALES Cash Provided by Operating Activities Cash Return on Sales Net Sales 

35. Cash flow per shareindicates the cash flow generated for each common share. CASH FLOW PER SHARE Cash Flow from Operating, Investing, and Financing Activities Number of Common Shares Cash Flow per Share 

36. Cash total debt coverageindicates the amount of cash to pay off total debt that is generated from operating activities. The ratio is the cash based counterpart to the debt to total assets ratio. CASH TOTAL DEBT COVERAGE Cash Provided by Operating Activities Cash Total Debt Coverage Average Total Liabilities 