Chapter 4: Reporting Financial Performance

Question 1

Statement of Financial Performance

Answer 1

The report that measures the success of a company’s operations for a specific time period has many names:
- Statement of income/earnings
- Income statement (ASPE)
- Two versions under IFRS
- Two separate statements: Statement of profit or loss and Statement of comprehensive income
- One combined statement: Statement of financial performance (per the newly issued IFRS Conceptual Framework)

Question 2

Business Models

Answer 2

The basic business model identifies three activities:
- Financing: Obtaining cash funding
- Investing: Use of funding to buy assets and invest in people
- Operating: Use of assets and people to generate profits

Different industries have different business models, and within industries, companies have different business models

Question 3

Value Creation

Answer 3

In performing business activities, companies are exposed to different levels of risk and are given different opportunities.

Value creation is finding the optimal balance between managing risks and taking the right opportunities

Market demands a greater return when there is greater risk: risk/return trade-off

Question 4

Communicating Information About Performance

Answer 4

The income statement helps users understand the business–
1. Evaluate past performance and profitability
- Statement of financial position is also useful in assessing profitability
2. Provide a basis for predicting future performance
- Use information about business risk and past performance
3. Help assess the risk of not achieving future net cash inflows
- By looking at relationships between the various components of income

Question 5

Quality of Earnings/Information

Answer 5

Shortcomings of the statement of income/comprehensive income:
- Items are excluded if they cannot be measured reliably
- Income numbers are affected by accounting methods used
- Use of estimates in measuring income
- Financial reporting bias
- GAAP is not always optimal

Question 6

Quality of Earnings

Answer 6

How solid earnings numbers are

Two main aspects to consider:
1. Content
- Integrity of information
- Sustainability of earnings
2. Presentation
- Earnings presentation is clear and concise
- Easy to use and understandable

Question 7

Characteristics of high quality earnings:

Answer 7

1. Nature of Content
   - Unbiased and objectively determined
   - Reflects economic reality
   - Reflects primary earnings from on-going core activities
   - Can be correlated with cash flows from operations
   - Based on sound business strategy/model
2. Presentation
   - Does not disguise or mislead (transparent)
   - Understandable

Question 8

Earnings Management

Answer 8

• Targeting earnings levels and then working backward to ensure the targets are met
  - Selection of specific accounting policies​
  - Use of aggressive assumptions/estimates
  - Presentation or results in the best light (rounding up)
• Increase income in the current year by reducing income in future years (or vice versa)
• Earnings management decreases quality of earnings
• Users should assess the quality of earnings before making decisions

Question 9

Measurement of Income

Answer 9

How do we measure income?

• IFRS generally supports the all-inclusive approach to measuring income
  - This results in “comprehensive income”
  - Comprehensive income includes any non-shareholder transactions that cause a change in equity
  - Example: unrealized gains/losses on revaluation of property, plant, and equipment under the revaluation model

Question 10

Other comprehensive income (OCI)

Answer 10

• = comprehensive income less net income
• Includes unrealized gains or losses on certain securities, certain foreign exchange gains or losses, and other gains and losses as defined by IFRS
• Some items are recycled: recognized first in OCI, then reclassified later to net income
• OCI is closed to an equity account on the SFP called Accumulated Other - Comprehensive Income (AOCI)
• Guidance on OCI (from IFRS Conceptual Framework)
  - All items of income and expense should be included in net income except under exceptional circumstances
  - In principle, all items should be recycled to net income as long as it results in relevant information that is representationally faithful
• ASPE continues to focus on net income as the measure of income
• Net income represents revenues and gains less expenses and losses from both continuing and discontinued operations

Question 11

Discontinued Operations

Answer 11

• Discontinued operations includes separate components that have been disposed of or are held for sale
• Components can include:
  - Under ASPE: an operating segment, reporting unit, subsidiary, asset group, or operations without assets
  - Under IFRS: separate major line of business or geographical area of operations, or a business qualifying as “held for sale” upon acquisition
• Discontinued operations are presented separately on the statement of income/comprehensive income net of tax

Question 12

Separate Component - Defined

Answer 12

• The business component must have operations, cash flows and financial elements that are clearly distinguishable from the rest of the enterprise
• Separate financial information is critical so gains or losses from discontinued operations can be measured
• The component must be a major line of business or a geographical area—however what is ”major” is a matter of judgement

Question 13

Assets Held for Sale

Answer 13

• If a component is not yet disposed of, it must be held for sale
• Criteria for an asset to be considered “held for sale”
  - Authorized plan to sell exists
  - Asset available for immediate sale
  - Active search for a buyer
  - Sale is probable within a year
  - Asset is reasonably priced and actively marketed
  - Changes to the plan are unlikely

Question 14

Assets Held for Sale - Measurement and Presentation

Answer 14

• Depreciation is not recognized on held for sale assets
• Remeasured at lower of carrying value and fair value net of cost to sell
• Once asset is written down, subsequent gains can be recognized only up to the amount of original loss
• Presented separately on balance sheet
  - Under ASPE, held for sale asset retains original classification as current or non-current
  - Under IFRS, held for sale assets generally classified as current

Question 15

Income Statement

Answer 15

Items included in continuing operations
- Revenues and Expenses
- Gains and Losses
- Unusual gains and losses:
- Not typical; occur infrequently
- Write-down of inventory; foreign exchange
- Included, but shown separately
- Discontinued operations shown below income from continuing operations
- Any other items that are material and/or relevant to understanding the financial performance presented separately

Under IFRS, the statement of comprehensive income can be presented either:
- As a single combined statement
- As two separate statements: traditional income statement and another statement beginning with net income, adding other comprehensive income for a total of comprehensive income

IFRS does not require the use of the terms comprehensive income or other comprehensive income

Question 16

Single-Step Income Statement

Answer 16

Presents only two groupings prior to Income before Discontinued Operations:
- Revenues (includes gains)
- Expenses (includes losses)

Income tax expense often reported separate from expenses as the last line item in determining net income

Advantages:
- Simplicity
- Eliminates classification problems for revenues and expenses
Disadvantage:
- Oversimplification
- Less detail (e.g. operating and non-operating activities reported together and cannot be distinguished)

Question 17

Multiple-Step Income Statement

Answer 17

• Operating and non-operating activities are separated
• Matches costs and expenses with related revenues
• Advantages:
  - Highlighting regular and irregular activities allows for greater predictive value and feedback value
  - Provides better detail to compare companies
  - Allows for better ratio analysis to assess performance
• Statements for external users have less detail than internal management reports

Question 18

Condensed Income Statement

Answer 18

• Expenses are reported on the income statement in group totals
• Details of the expense groups are included on supplementary schedules
• Provides the advantage of a concise, understandable income statement
• An example of trade-off between understandability and full disclosure
• Reduces “information overload”

Question 19

Presenting Expenses: Nature versus Function

Answer 19

• Under IFRS, analysis of expenses must be presented based on either:
  - Nature of expenses (e.g. purchase of materials, transportation costs, employee benefits, depreciation, etc.)
  - Function of expenses (e.g. cost of sales, administrative costs, etc.)
• Choice should result in information that is more reliable and relevant
• No similar guidance under ASPE
• Which method is better? Most companies use some combination of both for presentation

Question 20

Intraperiod Tax Allocation

Answer 20

• Refers to the allocation of income taxes within a period
• Relates income tax expense to the items being taxed
• Certain irregular items on the income statement are reported net of tax
• Specifically, income tax expense (or benefit) is calculated and presented separately for the following:
  1. Income from continuing operations
  2. Discontinued operations
  3. Other comprehensive income—although IFRS allows for either net of tax or before tax with one amount shown for taxes related to all items

Question 21

Earnings Per Share (EPS)

Answer 21

Not mandatory for ASPE. No share capital for sole proprietorships, partnerships, and NPOs. For private companies, shares are closely held so less relevant.

• Key indicator of a company’s performance
• Indicates dollars earned per common share; it does not report the dollars paid (or to be paid) per common share
• EPS based on earnings before discontinued operations and EPS based on net income must be shown on the face of the income statement
• EPS based on discontinued operations may be disclosed in the notes to the financial statements

Net Income less Preferred Dividends / Weighted Avg of Common Shares Outstanding

• EPS is subject to dilution (reduction) if issue of additional shares is possible in the future
• For such situations, both Basic EPS and Diluted EPS are presented

Question 22

Retained Earnings Statement (ASPE)

Answer 22

• Net income or net loss, declared dividends, correction of prior-period errors, changes in accounting estimates, and retroactively applied changes in accounting principles impact retained earnings
• Changes in accounting principle generally recognized through retrospective restatement
• If prior period statements are not restated, opening retained earnings would be adjusted (net of tax)
• Companies following ASPE usually prepare a separate statement of retained earnings; could be included jointly with the income statement

Question 23

Statement of Changes in Equity (IFRS)

Answer 23

• Under IFRS, need a statement that shows changes in each component of equity.
• Statement must include:
  1. Total comprehensive income (amounts attributed to owners and noncontrolling interests)
  2. Effects of retrospective application for each component
  3. Reconciliation between the carrying amount of each component of equity at the beginning and end of the period (profit or loss, OCI, transactions with owners)
• Often prepared in columnar form
• Analysis of OCI as items on the statement or in notes

Question 24

Disclosure

Answer 24

• Notes are a great source of background and explanatory information
• Cross-referenced to the main financial statements
• Should include:
  - Accounting policies
  - Sources of estimation uncertainty
  - Information about the capital of the company, and how it is managed
  - General information including dividends, legal form, country of incorporation, description of business name of parent company, other information required under the full disclosure principle

Question 25

Analysis

Answer 25

• Financial analysts and investors assess quality of earning
• Certain presentation formats assist users
• Look for and analyze
  - Accounting policies—aggressive, soft numbers
  - Notes to financial statements—unrecognized liabilities, asset overstatement
  - Measurement uncertainty—risk
  - Financial statements as a whole—complexity of presentation and language
  - Income statement—percentage of net income from ongoing operations
  - Cash flow statement—cash versus net income
  - Statement of financial position—financing and revenue-generating assets
  - Other—environmental factors, competition, strategic positioning, future of the industry