Session-3.pptx
- 2. Learning objectives × Identify the components and formats of the income statement and cash flow statement × Differentiate revenue recognition and expense recognition × Determine the nonrecurring items and non- operating items × Analyze income and cash flow statements 2
- 3. Hello! Do you have questions from our previous discussion? 3
- 4. 1. INCOME STATEMENT Let’s start with the first set of slides 4
- 5. Income Statement Components × Revenue -is the money an entity receives from the sale of goods or services. Other terms frequently used for revenue are sales, net sales, or sale revenue. It is also referred to as the “top line” because revenues are reported at the top of the income statement. × Cost of Goods Sold -Cost of goods sold are the direct costs of producing the goods being offered by the entity. This would include the materials, labor, and other resources required for production. × Gross Profit -Gross profit is the difference between the revenue received for the product less the cost of goods sold. × Operating Expenses -Operating expenses are the amount an entity expends to maintain and operate the general business. Operating expenses include research and development, marketing, general and administrative, amortization of intangible assets (i.e. patents, good will, etc.), etc. 5
- 6. Income Statement Components × Operating Income -Operating income is equal to revenues minus cost of goods sold and operating expenses. In other words, it measures the profits or losses of the day to day operations of the business. Another name for Operating Income is Earnings Before Interest and Taxes (EBIT). × Other Income/Expenses -To obtain net income, further adjustments must be made to account for interest income and expense, income tax expenses, and other extraordinary and miscellaneous items. × Profits -Revenues minus all expenses equals net income (profits or losses). Profits are also referred to as net income or the “bottom line” because profits are reported at the bottom of the income statement. Some analysts call these “accounting profits” because they include non-cash accounting entries such as depreciation and amortization. 6
- 7. 7 Income Statement Format Revenue – Cost of Goods Sold Expense = Gross Profit (or Loss) – Operating Expenses (R&D, selling & adm., depreciation, etc) = Operating Income Other Income/Expenses + investment income – Interest Expense – Taxes +/- Non Recurring Events (Extraordinary items) = Profit or Net Income
- 8. × Purpose of the Income Statement The purpose of the income statement is to provide the financial earnings performance of the entity over a specific period of time. It is also referred to as a profit and loss statement or earnings statement. 8
- 9. × Revenue recognition is a generally accepted accounting principle (GAAP) that identifies the specific conditions in which revenue is recognized and determines how to account for it. Typically, revenue is recognized when a critical event has occurred, and the dollar amount is easily measurable to the company. × On May 28, 2014, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) jointly issued Accounting Standards Codification (ASC) 606, regarding revenue from contracts with customers. ASC 606 provides a uniform framework for recognizing revenue from contracts with customers. The old guidance was industry-specific, which created a system of fragmented policies. The updated revenue recognition standard is industry-neutral and, therefore, more transparent. It allows for improved comparability of financial statements with standardized revenue recognition practices across multiple industries. 9
- 10. There are five steps needed to satisfy the updated revenue recognition principle: × Identify the contract with the customer. × Identify contractual performance obligations. × Determine the amount of consideration/price for the transaction. × Allocate the determined amount of consideration/price to the contractual obligations. × Recognize revenue when the performing party satisfies the performance obligation. 10
- 11. × The expense recognition principle states that expenses should be recognized in the same period as the revenues to which they relate. If this were not the case, expenses would likely be recognized as incurred, which might predate or follow the period in which the related amount of revenue is recognized. × This principle also has an impact on the timing of income taxes. In the example, income taxes will be underpaid in the current month, since expenses are too high, and overpaid in the following month, when expenses are too low. × Some expenses are difficult to correlate with revenue, such as administrative salaries, rent, and utilities. These expenses are designated as period costs, and are charged to expense in the period with which they are associated. This usually means that they are charged to expense as incurred. 11
- 12. When to Use the Expense Recognition Principle? × The expense recognition principle is a core element of the accrual basis of accounting, which holds that revenues are recognized when earned and expenses when consumed. If a business were to instead recognize expenses when it pays suppliers, this is known as the cash basis of accounting. × If a company wants to have its financial statements audited, it must use the expense recognition principle when recording business transactions. Otherwise, the auditors will refuse to render an opinion on the financial statements. 12
- 13. There are four types of non-recurring items in an income statement. 1. Discontinued operations Discontinued operations are not a component of persistent or recurring net income from continuing operations. To qualify, the assets, results of operations, and investing and financing activities of a business segment must be separable from those of the company. The separation must be possible physically and operationally, and for financial reporting purposes. Any gains or disposal will not contribute to future income and cash flows, and therefore can be reported only after disposal, that is - when realized. 2. Extraordinary items Extraordinary items are both unusual in nature and infrequent in occurrence, and material in amount. They must be reported separately (below the line) net of income tax. 13 Nonrecurring Items and Non-Operating Items
- 14. There are four types of non-recurring items in an income statement. 3. Unusual or infrequent items These are either unusual in nature or infrequent in occurrence but not both. They may be disclosed separately (as a single-line item) as a component of income from continuing operations. They are reported pre-tax in the income statement and appear "above the line," while the other three categories are reported on an after-tax basis and "below the line" and excluded from net income from continuing operations. 14 Nonrecurring Items and Non-Operating Items
- 15. 4. Changes in accounting principles Changes in accounting principles, such as from LIFO to another inventory method or from the percentage-of-completion method to the completed-contract method, can be either voluntary changes or changes mandated by new accounting standards. They are reported in the same manner as extraordinary items and discontinued operations. The cumulative impact on prior period earnings should be reported as a separate line item on the income statement on an after-tax basis. They are typically reported through retrospective application, which means that the financial statements for all fiscal years shown in a company's financial report are presented as if the newly adopted accounting principle had been used throughout the entire period. Changes in accounting estimates, such as changes in asset lives or salvage value when recording depreciation expenses, are not considered changes in accounting principles. The impact of such a change is only prospective, and no retroactive or cumulative effects are recognized. A change from an incorrect to an acceptable accounting method is treated as an error and its impact is reported as a prior period adjustment. 15 Nonrecurring Items and Non-Operating Items
- 16. Non-operating items are reported separately from operating items. For example, if a non-financial service company invests in equity or debt securities issued by another company, any interest, dividends, or profits from sales of these securities will be shown as non-operating income 16
- 17. Vertical Analysis × When you compare each line up and down the statement to the top line (which is revenue), this is called "vertical analysis." Each line item becomes a percentage of a base figure. This method can be used to compare one line item to another very simply, such as to check how each may affect cash flow, or it can be used to show how the cost of one line item stands up against the cost of any other. This can be helpful if, for instance, you are looking for a reason why a company might have taken certain actions, or where it may be spending in excess. Investors use this method for a dive deep into a company's current standing with regard to such metrics as working capital and total assets. 17
- 18. Horizontal Analysis × Horizontal analysis, on the other hand, compares the same figure across two or more time frames. This method is most often used for spotting trends. A single line item can be looked at over a long span of time, to view changes from year to year. For instance, you might wish to hone in on what factors may be driving a certain company's success (or failure) over the last few years. Some investors use this method to predict how well a company will perform in the months or years to come. 18
- 19. × Because income statements have a few limits, they may not always be the best source to consult. It depends on what you're looking for. Capital structure and cash flow, just to name two, can make or break a firm, and you'll want to have correct figures. 19 limits of
- 21. COMPONENTS OF CASH FLOW STATEMENT 21 1. Operating Activities: The principal revenue-generating activities of an organization and other activities that are not investing or financing; any cash flows from current assets and current liabilities. 2. Investing Activities: Any cash flows from the acquisition and disposal of long-term assets and other investments not included in cash equivalents 3. Financing Activities: Any cash flows that result in changes in the size and composition of the contributed equity capital or borrowings of the entity (i.e., bonds, stock, dividends)
- 22. 22 The direct method adds up all the various types of cash payments and receipts, including cash paid to suppliers, cash receipts from customers, and cash paid out in salaries. These figures are calculated by using the beginning and ending balances of a variety of business accounts and examining the net decrease or increase in the accounts. With the indirect method, cash flow from operating activities is calculated by first taking the net income off of a company's income statement. Because a company’s income statement is prepared on an accrual basis, revenue is only recognized when it is earned and not when it is received.
- 23. Cash flow statement analysis 23 A cash flow analysis determines a company’s working capital—the amount of money available to run business operations and complete transactions. That is calculated as current assets (cash or near-cash assets, like notes receivable) minus current liabilities (liabilities due during the upcoming accounting period). Analysis of working capital provides a snapshot of the liquidity of the business.
- 24. Five Steps to Cash Flow Analysis × Aim for positive cash flow When operating income exceeds net income, it’s a strong indicator of a company’s ability to remain solvent and sustainably grow its operations. × Be circumspect about positive cash flow On the other hand, positive investing cash flow and negative operating cash flow could signal problems. For example, it could indicate a company is selling off assets to pay its operating expenses, which is not always sustainable. × Analyze your negative cash flow When it comes to investing cash flow analysis, negative cash flow isn’t necessarily a bad thing. It could mean the business is making investments in property and equipment to make more products. A positive operating cash flow and a negative investing cash flow could mean the company is making money and spending it to grow. 24
- 25. Five Steps to Cash Flow Analysis × Calculate your free cash flow What you have left after you pay for operating expenditures and capital expenditures is free cash flow. This can be used to pay down principal, interest, buy back stock or acquire another company. × Operating cash flow margin builds trust The operating cash flow margin ratio measures cash from operating activities as a percentage of sales revenue in a given period. A positive margin demonstrates profitability, efficiency and earnings quality. 25
- 26. You are now ready for the quiz! 26
- 27. 27 Problem Solving Instruction: Read the following problems below and provide the required answer in each item. Solutions should be provided in each problem. Required: Perform trend analysis on the Income Statement of Ace Company above. Then provide your analysis in the given space below. (Minimum of 100 words)
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