Chapter 3: The Statement of Profit or Loss and Other Comprehensive Income PDF

Chapter 3 The Statement of Profit or Loss and Other Comprehensive Income Textbook pages: 115 - 136 Intermediate Accounting I Dr. Charles Kang 3-1  Statement of Profit or Loss General Format McAllister’s Manufacturing Sta...

Chapter 3 The Statement of Profit or Loss and Other Comprehensive Income Textbook pages: 115 - 136 Intermediate Accounting I Dr. Charles Kang 3-1  Statement of Profit or Loss General Format McAllister’s Manufacturing Statement of Profit or Loss Years Ended December 31 ($ in millions, except earnings per share) 2023 2022 Profit from Sales revenue $1,450.6 $1,380.0 Continuing Cost of goods sold 832.6 800.4 Operations Gross profit 618.0 579.6 Operating expenses: Selling 123.5 110.5 General and administrative 147.8 139.1 Research and development 55.0 65.0 Restructuring costs 125.0 – Total operating expenses 451.3 314.6 Operating profit 166.7 265.0 Other income (expense): Interest income 12.4 11.1 Interest expense (25.9) (24.8) Gain on sale of investments 18.0 19.0 Profit from continuing operations before income taxes 171.2 270.3 Income tax expense 59.9 94.6 Profit from continuing operations 111.3 175.7 Discontinued Discontinued operations: Operations Loss from operations of discontinued component (including gain on disposal in 2023 of $47) (7.6) (45.7) Income tax benefit 2.0 13.0 Loss on discontinued operations (5.6) (32.7) Net profit $ 105.7 $ 143.0 Earnings per Earnings per share—basic: Share Profit from continuing operations $ 2.14 $ 3.38 Discontinued operations (0.11) (0.63) Net profit $ 2.03 $ 2.75 Earnings per share—diluted: Profit from continuing operations $ 2.06 $ 3.25 Discontinued operations (0.10) (0.61) Net profit $ 1.96 $ 2.64 3-2  LO3-2 Profit From Continuing Operations eg. ABC COMPANY Sell football, tennis Revenues Expenses Gains and Losses Inflows of Outflows of resources resources Increases or resulting from incurred decreases in providing while equity from related to the core business of the company goods or generating peripheral or what you do services to revenues. incidental on your side customers. outflow of resources that will decrease the equity of the company transactions of with respect to the operation of the company inflow of resource that will increase the equity of the company (major core business, what you do as a company) an entity. empty office space: selling real estate eg. book value of 15 million sold for 20 million —> gain of 5 million 3-3 Profit From Continuing Operations McAllister’s Manufacturing Statement of Profit or Loss Years Ended Dec. 31 ($ in millions, except earnings per share) 2023 2022 Profit from Sales revenue (sometimes its called “revenue”) $1,450.6 $1,380.0 Continuing Cost of goods sold expenses Sales - COGS = GP 832.6 800.4 Operations Gross profit 618.0 579.6 Operating expenses: Selling 123.5 110.5 General and administrative coming from the second bucket 147.8 139.1 Research and development 55.0 65.0 Restructuring costs 125.0 – Total operating expenses 451.3 314.6 Operating profit 166.7 265.0 Other income (expense): nth to do with your core business Interest income Gains and losses 12.4 11.1 Interest expense borrow money from the bank? (25.9) (24.8) Gain on sale of investments 18.0 19.0 Profit from continuing operations before income taxes 171.2 270.3 Income tax expense 59.9 94.6 Profit from continuing operations 111.3 175.7 3-4  Statement of Profit or Loss Formats: Function of Expense Method More commonly accepted method Function of the expense Expenses are MAXWELL GEAR CORPORATION Statement of Profit or Loss classified by their For the Year Ended December 31, 2023 Sales revenue $557,222 function within the Cost of goods sold revenue (core operation) $302,371 company, as part of Gross profit Operating expenses: expenses (core operation) 254,851 cost of sales, cost of Selling and distribution $47,431 General and administrative 24,888 distribution, cost of Total operating expenses 72,229 Operating income 182,622 administration, and Other income (expense): other functions. Interest and dividend revenue 26,400 Gain on sale of investments 5,500 intermediate metrix: this approach should be better Interest expense (14,522) as some intermediate metrix that are useful for investors Total other income, net 17,378 Profit before tax gains and losses 200,000 Tax expense 40,000 Net profit $160,000 3-5  Statement of Profit or Loss Formats: Nature of Expense Method Expenses are classified by their nature. MAXWELL GEAR CORPORATION Statement of Profit or Loss For the Year Ended December 31, 2023 Revenues and gains: What do Sales $557,222 Interest and dividends 26,400 you Gain on sale of investments 5,500 notice? Total revenues and gains 589,122 Expenses: Changes in finished goods and $240,371 work in progress inventory What do Raw materials used 75,667 Employee-related 18,682 you Depreciation and amortization 10,000 notice? Advertising 30,000 Interest 14,522 Total expenses 389,122 Profit before tax 200,000 Tax expense 40,000 Net profit $160,000 3-6  IFRS Versus US GAAP—Statement of Profit or Loss Presentation IFRS US GAAP Statement of Profit or Loss Presentation Require certain minimum No minimum requirements information on the statement of profit or loss. Expenses are classified SEC requires expenses to either by nature or function. be classified by function. “Bottom line” is either profit “Bottom line” is either net or loss Terminology difference income or net loss 3-7  decide to get rid of one side of our business Discontinued Operations held for sale tale a couple months to really sell the thing but need to categorise it seperately classify it seperately If a company discontinues or sells a part of its business, profits from these discontinued operations will not continue. Profit or loss from discontinued operations is reported separately, below profit from continuing operations. Profit from continuing operations before income taxes $1,000 Income tax expense (assuming 20%) 200 Profit from continuing operations 800 (net of tax) Profit from discontinued operations, $100 net of $20 tax expense all the numbers below should be net of tax 80 Net profit $880 3-8  division, component, segment, line of business Reporting Discontinued Operations— When the Component Has Been Sold 1. successfully sell the component 2. havent sold the component by the year eg. In June, you found a buyer by December --> it usually takes a while to find someone who is willing to buy their component When the discontinued component is sold before the end of the reporting period, income effects will include Profit or loss from Gain or loss on operations of the + disposal of the component from the component’s assets beginning of the reporting period to the disposal date (Sale) 3-9 after tax profit from continuing operations of 20M less: loss from operations 5 Discontinued Operations Example— add: income tax benefit 1 —- 16 add: gain from disposal Component Has Been Sold net of tax 3*0.8 2.4 — 18.4 In October 2023, management of Duluth Holding Company decided to sell one of its divisions that qualifies as a separate component according to IFRS. The division was sold on December 18, 2023. Consider the following facts: 1. From January 1 through disposal, the division had a pre-tax loss from operations of $5,000,000. 2. The assets of the division had a net selling price of $15,000,000 and a book value of $12,000,000. Gain = $3,000,000 Duluth’s statement of profit or loss for 2023, beginning with after-tax profit from continuing operations of $20m, would be reported as follows (assume 20% tax): Profit from continuing operations $20,000,000 Discontinued operations: Loss from operations of discontinued $(2,000,000) component (including gain on disposal of $3,000,000) Income tax benefit [2,000,000*20% = 400,000] 400,000 (1,600,000) Loss on discontinued operations Net profit $18,400,000 3-10  Reporting Discontinued Operations— When the Component is Held for Sale When the discontinued component has not been sold when the reporting period ends, the income effects are reported but modified Profit or loss from An impairment loss operations of the if the book value of component from the the assets of the beginning of the reporting + component is more period to the end of the than the fair value reporting period minus cost to sell 3-11  Discontinued Operations Example— Component Held for Sale can only include losses but not the gains In October 2023, management of Duluth Holding Company decided to sell one of its divisions that qualifies as a separate component according to IFRS. On December 31, 2023, the end of the company’s financial year, the division had not yet been sold. Consider the following facts related to the division: 1. For the year, the division reported a pre-tax loss from operations of $5,000,000. 2. On December 31, assets of the division had a book value of $12,000,000 and a fair value minus anticipated cost to sell of $9,000,000. Loss = $3m Duluth’s statement of profit or loss for 2023, beginning with after-tax income from continuing operations of $20m, would be reported as follows (assume 20% tax): Profit from continuing operations $20,000,000 Discontinued operations: Loss from operations of discontinued component (including impairment loss $(8,000,000) of $3,000,000) Income tax benefit [8,000,000*20%=1,600,000] 1,600,000 Loss on discontinued operations (6,400,000) Net profit $13,600,000 3-12  Discontinued Operations Example— Component Held for Sale: Do it in Class In October 2023, management of Duluth Holding Company decided to sell one of its divisions that qualifies as a separate component according to IFRS. On December 31, 2023, the end of the company’s financial year, the division had not yet been sold. Consider the following facts related to the division: 1. For the year, the asymmetric division treatment reported a pre-tax loss from operations of $5,000,000. —> protect against the incentive to be optimistic —> accounting conservatism unrealised gain 2. On December 31, assets of the division had a book value of $12,000,000 and a fair value minus anticipated cost to sell of $14,000,000. Duluth’s statement of profit or loss for 2023, beginning with after-tax income from continuing operations of $20m, would be reported as follows (assume 20% tax): Profit from continuing operations 20 $... Discontinued operations: Loss from operations of discontinued 5 component... 1 Income tax benefit... Loss on discontinued operations 4... Net profit 16 $.... Further Discussions in Class 3-13  Earnings Quality Ability of reported earnings (profit) to predict a company’s future earnings current earnings eg. 20 Million make forcase about future earnings rate = reasonable forecast next year the income turns out to be 20M (high predicted value to predict next years’ proft) —> high predictive value (what we want accounting data to have) Temporary earnings Not likely to occur again in the foreseeable future Result from transactions that are: Likely to have a different impact more likely to generate permenant earnings on earnings in the future Permanent earnings Result from transactions Profit from continuing likely to generate similar operations may include profits in the future temporary earnings effects 3-14 Earnings Quality In General, when it comes to earnings quality Repeated = more predictive (every year will have similar numbers) ‘Income from Continuing Operations’ > ‘Income from discontinued operations’ Within the Income from Continuing Operations: ‘Operating Profit’ > ‘Non-operating Income’..but there are exceptions. Let’s discuss some of them. 3-15  Operating Profit and Earnings Quality restructuring cost is classified in the operating expenses Costs associated with Restructuring Costs shutdown or relocation of (May or may not recur) facilities or downsizing of IFRS require them to disclose as operating expenses operations are recognized in the period incurred. Other Unusual Items: Goodwill Impairment Tangible or intangible asset balance reduced and Asset major operating issues —> but it is one-off for impairment of value. Impairment major change Loss of major customer, Revenue Issues revenue misstatement, or premature revenue recognition. 3-16  Nonoperating Profit and Earnings Quality Some items in a statement of profit or loss relate only tangentially to continuing operations. We refer to these as nonoperating items. long term loan say 20 years at 10% interest rate (10M loan) 1 million interest expense every year Examples: —> the same number every year —> those numbers do recur —> higher predictive value and high earnings qualiity – Interest income or interest expense – Gains or losses on sale of investments Some of these items may recur (e.g., interest income or expense), while others are less likely to recur (e.g., gains or losses). Even if they recur, theses items are not related to the core business of the company….but does it matter? …Discuss in class 3-17 Voluntary disclosures --> non- GAAP earnings Pro Forma Earnings company come up with their metrix (company’s own definition of earnings) (or Non-GAAP Earnings) Companies are required to report earnings based on relevant accounting standards. Most companies voluntarily provide pro forma earnings (also known as non-GAAP earnings), which exclude certain revenues and expenses. – Examples: Restructuring costs, acquisition costs, write-downs of impaired assets, and share-based reasoning: these expense dont have earnings quality compensation. (not recurring many times) Non-GAAP earnings are controversial since the expenses to exclude are at the discretion of management Prior research shows that non-GAAP expenses that are excluded from Pro-forma earnings are quite likely to occur again!! Can we make a trading strategy? 3-18  Reporting Manipulation: Income Smoothing and Classification Shifting Income smoothing – Within IFRS, create smoother pattern in earnings over time by altering assumptions and estimates. – Overestimate expenses in current year to reduce net profit, and then reverse those estimates in future years to increase net profit. benchmark shifting the earning from year one to year 2 Classification shifting shift within year but within different part of your financial statement – Shifting operating expenses to nonoperating expense classification to report higher operating profit. OR shift from continued operations to discontinued operation further down the line 3-19 Reporting Manipulation An important reason to manipulate earnings is to meet or beat the market expectations (analyst consensus) or avoid reporting a loss Research shows that some mild form of earnings manipulation is quite widespread—Burgstahler & Dichev (1997) strong incentive to avoid a loss A small amount of manipulation is almost impossible to catch (The company can provide valid reasons for its accounting choices) negative earning —Burgstahler & Dichev (1997) 3-20  Comprehensive Income Provides a broader perspective of income and includes all revenues, expenses, gains, and losses for the period – Includes net profit plus other changes in shareholders’ equity that do not represent transactions with owners Comprehensive = Net + Other Income Profit or Comprehensive Loss Income Other comprehensive income (OCI) items: – Revaluation surplus – Unrealized holding gains and losses on investments – Gains (losses) from post-employment benefit plans – Deferred gains (losses) on derivatives – Foreign currency translation gains (losses) 3-21  Comprehensive Income Format (Illustration 3-1) ($ in millions) Net profit $xxx Other comprehensive income: Revaluation surplus $x Unrealized holding gains (losses) on (x) investments (net of tax) Gains (losses) from amendments to post- (x) employment defined benefit plans (net of tax) Deferred gains (losses) on derivatives (net of tax) x Foreign currency translation gains (losses) on x xx foreign operations (net of tax) Comprehensive income $xxx 3-22  Flexibility in Reporting Information in the statement of profit or loss and other comprehensive income items can be presented as: Single, continuous Two separate, but statement consecutive statements Statement of profit or loss and other Statement of Statement of comprehensive profit or loss comprehensive income income 3-23  LO3-8 IFRS Versus US GAAP — Comprehensive Income IFRS US GAAP Comprehensive income is presented either in a single, continuous statement or in two separate statements. Similar OCI items, but an Similar OCI items, except for additional item, changes in revaluation surplus. US GAAP revaluation surplus, is possible. prohibits the revaluation model. Not required to report Required to report AOCI as a accumulated other separate component of equity in comprehensive income (AOCI). the statement of financial position. 3-24  Accounting Changes Accounting changes fall into one of two categories accounting policy change in accounting estimate 3-25  Change in Accounting Policy Refers to a change from one acceptable accounting method to another. Voluntary changes in accounting policies Accounted for retrospectively by revising prior years’ financial statements. Example: Change in inventory costing method Mandated changes in accounting policies Implementation approaches – Retrospective approach [discuss in class] – Modified retrospective approach [discuss] – Prospective approach [discuss] 3-26  Change in Depreciation or Amortization Method Considered to be a change in accounting estimate. Accounted prospectively. Accounted for the same way as a change in an accounting estimate (see next slide). 3-27 Change in Accounting Estimate Changes due to modification of estimate as new information comes to light. Accounted prospectively. If the effect of the change is material, a disclosure note is needed to describe the change and its effect on net profit or loss and earnings per share. Examples: – Amount of future bad debts on existing accounts receivable. – Useful life and residual value of depreciable asset. – Future warranty expenses. 3-28