1 © 2007 by nelson, a division of thomson canada limited. chapter 3: measuring and evaluating...

1 © 2007 by Nelson, a division of Thomson Canada Limited.

CHAPTER 3:CHAPTER 3:

Measuring and Measuring and EvaluatingEvaluating

Financial Financial PerformancePerformance


Main topics in Chapter 3:

Some relevant history, particularly about the development of stock markets and the resultant interest in evaluating financial performance

Introduction to the income statement and RE statements Format of income and RE statements More on the underlying accounting mechanisms, including

accrual adjustments Introductory interpretation and analysis of the income statement Some comments on earnings management and other actions by

management to influence what the income statement reports

CHAPTER 3Measuring and Evaluating Financial Performance


HistoryHistory

In the mid 1600’s companies began selling shares (stocks) to private investors

The stock market emerged as business grew in size and complexity

Investors wanted updated reports on how well their companies were doing. They demanded accurate summaries of the financial position and performance of the company

Emergence of Corporations

Need to audit financial statements

Need for periodic financial statements

Separation of management

from ownership

Increase in the number of

owners (shareholders)

Longer life than

proprietorship and joint ventures

Income statements began to evolve when legislation required that dividend payments made to shareholders come out of the yearly income (Revenue – Expenses)

The income statement was proof for corporations that they had performed well enough to permit the distribution of dividends or the issuance of more shares

By 1920, annual financial statements for public companies were mandatory in Canada

Demand for Regulation of Financial AccountingDemand for Regulation of Financial Accounting

Complexity and diversity in accounting methods

Corporate failures

Difficulty to analyze financial statements

Need for consistency in accounting methods

TENSION

Self-regulation by the accounting profession

Regulation of the profession by government


The Generally Accepted Accounting Principles are the conceptual structures behind financial accounting

Includes rules, standards, and common practices that companies are expected to follow

Generally Accepted Accounting PrinciplesGenerally Accepted Accounting Principles

CICA handbook began about 30 years ago as a successful attempt by the Canadian Institute of Chartered Accountants to develop more rigorous accounting and auditing standards for

Canada.


Some RegulatorsSome Regulators

CANADA• CICA Handbook• Ontario Securities Commission (OSC)

UNITED STATES• Financial Accounting Standards Board (FASB)• Securities and Exchange Commission (SEC)

INTERNATIONAL• International Accounting Standards Committee (IASC)

GLOBALIZATION• Economic globalization, therefore pressure to harmonize

accounting standards internationally

Financial PositionFinancial Position Financial PerformanceFinancial Performance

Balance Sheet as at Dec.31, 2005

Events during 2006 affectingonly the balance sheet

Balance Sheet as at Dec.31, 2006

Income Statement for the year 2006

Statement of Retained Earningsfor the year 2006


What is Income?What is Income?

Income is the ability to generate new resources through day-to-day operations

Income is the “bottom line” measure of performance

Income is based on accrual accounting’s broad, judgmental (though constrained) framework

Net Income (or the per-share version, EPS) is the most-quoted accounting number

Defined by: Income = Revenues - Expenses



Revenues are increases in the company’s wealth arising from the provision of services or sale of goods to customers. Wealth increases because customers either pay cash, promise to pay cash, or pay with other forms of wealth.

Expenses are decreases in the company’s wealth that are incurred in order to earn revenues. A major expense category is the cost of goods sold (COGS) expense. COGS is the cost to the enterprise of the goods given up to generate the revenue.

Payments of returns to owners (withdrawals by proprietors and partners and dividends to shareholders) are not included in expenses. Income is measured before such payments.


Expenses other than income taxIncome

tax expense

Expenses other than income tax


Revenues

Net IncomeNet Income

Revenues

Income before tax

Income before tax


Why does the Income Statement Exist?Why does the Income Statement Exist?

Purpose is to measure the financial performance of an organization over a period of time (net income)

Displays the components of income (Revenues minus Expenses) – this would be messy if it were done in the Equity section of the balance sheet

Provides data for analyzing financial performance (the balance sheet focuses on financial position)


Why does the Statement of Retained Earnings Exist?Why does the Statement of Retained Earnings Exist?

It connects (“articulates”) the income statement to the balance sheet

It shows any non-operating items affecting retained earnings (especially dividends)

Income and Retained Earnings Statements’ General Income and Retained Earnings Statements’ General FormatFormat

Income Statement(for a specified period)

Revenues

Deduct Expenses

=Income before Income tax

Deduct income tax expense

=Net income

Retained Earnings Statement

(for a specified period)

Beginning Balance

Add net income

Deduct dividends declared

=Ending Balance

To Balance Sheet


Features of the Income StatementFeatures of the Income Statement

For a specific period of time Revenues first, then expenses Income before tax is shown explicitly

Then income tax expense

EPS equals Net Income/ # of shares outstanding

Income(loss) from discontinued operations and extraordinary items comes next

Net Income


Features of the Statement of Retained EarningsFeatures of the Statement of Retained Earnings

For a specific period of time (over the same time period as the income statement)

Not necessarily a separate statement (can be at the bottom of the income statement)

Usually done only for corporations

Dividends declared are deducted

Sometimes other non-operating items


Features of the Income and Retained Earnings Features of the Income and Retained Earnings StatementsStatements

The statements cover a period of time ending at balance sheet date.As for balance sheet, explanatory notes are referred to & appended.The income statement is broken up into several different sections, starting with “ordinary” income and expenses, then moving on to items such as “extraordinary” or “discontinued operations”.

The net income from the income statement is carried down to the statement of retained earnings.

The statement of retained earnings starts with the beginning balance, adds the net income from the income statement, and deducts the dividends declared.


Content of the Income and Retained Earnings Content of the Income and Retained Earnings Statements’- Canadian Pacific Railway Inc.Statements’- Canadian Pacific Railway Inc.

CPR’s revenue increased from 2003 to 2004, as it increased to $3,902.9 million from $3,660.7 million.Total expenses increased by a relatively lower amount - $183.3 million - causing Operating Income to increase from 2003 to 2004.

Since CPR is a service company, it is impossible to calculate a gross margin. Employee compensation and fuel are two the of the most important expenses.In looking at interest expense, it can be seen that the company’s net cost of borrowing stayed the same, at $218.7 mil in 2003 and $218.6 mil in 2004. The overall interest expense has been netted against interest income.


Content of the Income and Retained Earnings Content of the Income and Retained Earnings Statements’- Canadian Pacific Railway Inc.(cont.)Statements’- Canadian Pacific Railway Inc.(cont.)

Below the net income figure is the earning per share (EPS) ratio. It is calculated as net income divided by the average # of common shares outstanding for the year. The first figure is for the current number of outstanding shares and the second, diluted figure, accounts for any stock options the company has issued that have yet to be exercised. In the retained earnings statement, CPR paid out dividends on two kinds of shares. The ordinary shares are related to the spin-off from the former CP. Dividends applicable to CPR’s new shares are listed under common shares.

Since we have both the income tax amount and net income, we can deduce the company’s tax rate as 25.8% in 2004 ($143.3/$556.3) and 9.4% in 2003 ($41.6/$442.9).


““What if”analysis- CPRWhat if”analysis- CPR

Scenario: “what if” CPR discovered that a $1 million freight sale wasn’t recorded until the 2004 fiscal year, but should have been

recorded in 2003. The accompanying expense was recorded in 2003.

What would recording this sale properly in 2003 do to:

a) 2003 continuing income before income tax

b) 2003 net income

c) 2003 ending working capital

d) 2003 ending retained earnings

e) 2004 revenue

by $1 million

by $906,000 (after deducting 9.4% income tax)

by $1 million

by $906,000 (the increase in NI)

by $1 million


Format of the Income StatementFormat of the Income Statement

Revenue $XXXXOperating expenses (COGS may be disclosed separately) XXXX

Nonoperating itemsOrdinary items $XXXXAny unusual items separately disclosed XXXX

Income tax expense (current and future/deferred portions) XXXX

Any discontinued operations, net of income tax $XXXXAny extraordinary items, net of income tax XXXX

Operating income $XXXX

XXXXContinuing income before income tax $XXXX

Income from continuing operations $XXXX

XXXXNet income for the year $XXXX

(goes to the statement of RE)


Format of the Income and Retained Earnings Format of the Income and Retained Earnings Statements’Statements’

The income statement begins with the more ordinary, regular revenues and expenses, and separates those from significant non-ordinary accounts shown further down.There may be ordinary items that are unusual in size and so may be disclosed separately.To signal the company’s ability to generate income, most income statements report a subtotal called Income before income tax, or Continuing income before income tax.Income tax expense, which includes amounts payable currently and amounts estimated in the future (called future or deferred) is deducted next. Including both current and future tax is called interperiod tax allocation.


Format of the Income and Retained Earnings Format of the Income and Retained Earnings Statements’Statements’

The nonordinary items are added or deducted next. Since income tax has already been deducted, these items should be net of income tax. The 2 main nonordinary items shown at the bottom of the income statement are discontinued operations and extraordinary items.The income statement’s “bottom line” is the net income, which is the income from continuing operations plus or minus any discontinued operations or extraordinary items.Earnings per share (EPS) is usually shown both before and after extraordinary and discontinued items.Net income from the income statement is transferred to the statement of retained earnings.


Format of the Retained Earnings StatementFormat of the Retained Earnings Statement

Retained earnings as reported at the end of the prior period $XXXXAny adjustments to beginning balance for error corrections or accounting policy changes, net of income tax XXXX

Add or deduct any adjustments from transactions with shareholders, net of tax XXXXDeduct dividends declared during the period XXXX

Revised beginning retained earnings $XXXX

Ending retained earnings $XXXX

(goes to the balance sheet)(not from IS)

Add net income (or deduct net loss)XXXX from income statement

2005 Events in 2006

Income statementIncome

statement

Beginningbalance sheet

(Dec. 31, 2005)

Beginningbalance sheet

(Dec. 31, 2005)

2007

Retained earnings Retained earnings

Endingbalance sheet

(Dec. 31, 2006)

Endingbalance sheet

(Dec. 31, 2006)

Sequence of ReportingSequence of Reporting


MEGALOMANIA INC.MEGALOMANIA INC.Account Balances at August 31, 2005

Accounts (millions of dollars) Statement Name $ B/S R/E I/S

1) Bank balance 21

2) Bank loan due on demand 42

3) Beginning retained earnings 214

4) Cash on hand 4

5) Common shares issued 130

6) Cost of goods sold 317

7) Amortization this year 19

8) Amortization accum. to date 68




9) Dividends declared 12

10) Income tax not yet paid 6

11) Expenses paid in advance 17

12) Factory building 187

13) Factory equipment 123

14) Tax on this year’s income 15

15) Interest incurred on debts 13

16) Land under factory 50




17) Administrative expenses 60

18) Marketing expenses 41

19) Mortgage payable 58

20) Operating expenses 124

21) Owing by customers 112

22) Payable to suppliers 87

23) Sales revenue 610

24) Supplies on hand 11




25) Unsold goods on hand 103

26) Unusual gain 10

27) After-tax loss on disc. operations 22

28) After-tax extraordinary gain 27

29) Deduction from RE (prior error) 5

30) Still owing on dividends 4


MEGALOMANIA INC.MEGALOMANIA INC.Income Statement for the Year ended August 31, 2005 (millions)

Sales revenue $610Expenses:Cost of goods sold $317Amortization 19Operating, marketing, and administration 225

Unusual gain 10

Income tax expense 15

Loss on discontinued operations (after-tax) ($22)

Interest incurred 13 57436

Income from continuing operations $31

Extraordinary gain (after-tax) 27 5 Net income for the year $36

Continuing income before income tax $46

(goes to the statement of RE)


MEGALOMANIA INC.MEGALOMANIA INC.Statement of Retained Earnings for the Year ended August 31, 2005 (millions)

Beginning balance $214Deduct: Prior period error 5

Add net income for the year 36

Deduct dividends declared during the the year 12245

Ending balance $233

Revised beginning retained earnings $209

(goes to the balance sheet)


MEGALOMANIA INC.MEGALOMANIA INC.Balance sheet as at August 31, 2005 (millions)

Assets Liabilities and EquityCurrent assets: Cash on hand and in bank $25 Accounts receivable 112 Inventory 103 Supplies 11 Prepaid expenses 17

$268Non-current assets: Land $50 Factory building 187 Factory equipment 123 Less: accum. amortization (68)

$292

Current liabilities: Demand bank loan $42 Accounts payable 87 Dividends payable 4 Income taxes payable 6

$139

Shareholders' equity: Share capital $130 Retained earnings 233

$363

Non-current liabilities: Mortgage payable 58

$197

TOTAL $560 TOTAL $560


AssetsCurrent assets: Cash $3,200 Inventory of unsold food 800 Inventory of supplies 2,350

$6,350Non-current assets: Equipment $9,200 Accum. Amortization (1,500)

$7,700

$14,050

Liabilities and Shareholders' EquityCurrent liabilities: Owing to suppliers $1,550 Sales and other taxes owing 100

$1,650Non-current liabilities: Loan to buy equipment 3,900

$5,550Shareholders' equity: Share capital contributed $4,100 Retained earnings 4,400

$8,500$14,050

CappuMania Inc.Balance Sheet as at March 31, 2006


Journal Entries- CappuManiaJournal Entries- CappuMania

1. RevenueDR Cash (assets increased) 85,250DR Accounts receivable (assets increased) 4,490 CR Revenue (equity increased) 89,740

2. General expensesDR General expenses (equity decreased) 67,230 CR Cash (assets decreased) 2,120 CR Accounts payable (liabilities increased) 65,110



3. Using up of inventoriesDR General expenses (equity decreased) 250 CR Inventory of unsold food (assets decreased) 250DR General expenses (equity decreased) 610 CR Inventory of supplies (assets decreased) 610

4. Amortization of equipmentDR Amortization expense (equity decreased) 2,380 CR Accumulated amortization (assets decreased) 2,380



5. Estimated income tax expenseDR Income tax expense (equity decreased) 4,460 CR Sales and other taxes owing (liabilities increased) 4,460

6. Dividend declaredDR Retained earnings (equity decreased) 1,000 CR Dividend payable (liabilities increased) 1,000

7. Collections of accounts receivableDR Cash (assets increased) 3,330 CR Accounts receivable (assets decreased) 3,330



8. Payments of accounts payableDR Accounts payable (liabilities decreased) 59,420 CR Cash (assets decreased) 59,420

9. Payments toward income taxDR Sales and other taxes owing (liabilities decreased) 3,000 CR Cash (assets decreased) 3,000

10. Payment toward dividendDR Dividend payable (liabilities decreased) 800 CR Cash (assets decreased) 800

Cash 26,440Accounts receivable 1,160Inventory of unsold food 550Inventory of supplies 1,740Equipment cost 9,200Accumulated amortization (3,880)Accounts payable (7,240)Sales and other taxes owing (1,560)Dividend payable (200)Loan to buy equipment (3,900)Share capital contributed (4,100)Retained earnings (3,400)Revenue (89,740)General expenses 68,090Amortization expense 2,380Income tax expense 4,460

Total 0

CappuMania Inc.CappuMania Inc.March 31, 2006 Trial Balance


CappuMania Inc.CappuMania Inc.Income Statement for the Year Ended

March 31, 2006

Revenue $89,740

Estimated income tax expense 4,460

Expenses: General $68,090 Amortization 2,380 70,470Income before income tax $19,270

Net income for the year $14,810

Closing Entry- CappuManiaClosing Entry- CappuMania

DR Revenue 89,740CR General expenses 68,090CR Amortization expense 2,380CR Income tax expense 4,460CR Retained earnings (the net income) 14,810

Retained earnings, beginning of year $ 4,400Add net income for the year

Deduct dividends declared during the year 1,000$19,210

Retained earnings, end of year $18,210

CappuMania Inc.Statement of Retained Earnings

For the Year Ended March 31, 2006

14,810


CappuMania Inc.CappuMania Inc.Balance Sheet as at March 31, 2006

Liabilities and Shareholders' EquityCurrent liabilities: Accounts payable $7,240 Sales and other taxes owing 1,560 Dividend payable 200

$9,000Non-current liabilities: Loan to buy equipment 3,900


$22,310$35,210

AssetsCurrent assets: Cash $26,440 Accounts receivable 1,160 Inventory of unsold food 550 Inventory of supplies 1,740

$29,890Non-current assets: Equipment cost $9,200 Accumulated amortization (3,880)

$5,320

$35,210


Tanya’s Footwear LtdTanya’s Footwear Ltd..Balance Sheet as at December 31, 2005Balance Sheet as at December 31, 2005

AssetsCurrent assets: Cash & ST investments $25,090 Accounts receivable 25,130 Unsold inventory 98,200 Prepaid expenses 15,320

$163,740Non-current assets: Buildings $80,890 Less: Accum. amortization (40,510)

$40,380

$204,120

Liabilities and Shareholders' EquityCurrent liabilities: Accounts payable $85,010 Wages payable 15,345

$100,355Non-current liabilities: Bank loan payable 12,590


$91,175$204,120


Journal Entries- Tanya’sJournal Entries- Tanya’s

1. Payments of wages payableDR Wages payable (liabilities decreased) 7,420 CR Cash (assets decreased) 7,420

2. Recognize cost of goods soldDR Cost of goods sold 22,750 CR Unsold inventory 22,750

3. Dividend declaredDR Retained earnings (equity decreased) 3,450 CR Dividend payable (liabilities increased) 3,450


4. Issuance of new sharesDR Cash (assets increased) 4,700 CR Share capital contributed (equity increased) 4,700

5. Purchase of suppliesDR Supplies (assets increased) 2,000 CR Accounts payable (liabilities increased) 2,000

6. Collections of accounts receivableDR Cash (assets increased) 26,210 CR Accounts receivable (assets decreased) 26,210



7. Receipt and use of bank loan for expansionDR Cash (assets increased) 15,000 CR Bank loan payable (liabilities increased) 15,000DR Buildings (assets increased) 15,000 CR Cash (assets decreased) 15,000

8. Amortization of buildingDR Amortization expense (equity decreased) 6,000 CR Accum. amortization (assets decreased) 6,000

9. Payment of dividendDR Dividend payable (liabilities decreased) 3,450 CR Cash (assets decreased) 3,450



10. Incurred selling & admin. costsDR Selling and admin. expenses (equity decreased) 61,965 CR Cash (assets decreased) 17,000 CR Accounts payable (liabilities increased) 36,045 CR Prepaid expenses (assets decreased) 8,920

11. Payment of accounts payableDR Accounts payable (liabilities decreased) 43,000 CR Cash (assets decreased) 43,000

12. RevenueDR Cash (assets increased) 73,450DR Accounts receivable (assets increased) 71,320 CR Revenue (equity increased) 144,770



13. Estimated income tax expenseDR Income tax expenses (equity decreased) 14,660 CR Sales and other taxes payable (liab. increased) 14,660

14. Purchase of inventoryDR Unsold inventory (assets increased) 21,040 CR Cash (assets decreased) 21,040

15. Accrued wage expenseDR Wage expense (equity decreased) 3,500 CR Wages payable (liabilities increased) 3,500



Tanya’s Footwear Ltd.Tanya’s Footwear Ltd.Trial Balance at December 31, 2006Trial Balance at December 31, 2006

DRCash & ST investments 37,540Accounts receivable 70,240Unsold inventory 96,490Supplies 2,000Prepaid expenses 6,400Buildings 95,890Cost of goods sold expense 22,750Amortization expense 6,000Selling and admin. expenses 61,965Income tax expense 14,660Wage expense 3,500

417,435


Tanya’s Footwear Ltd.Tanya’s Footwear Ltd.Trial Balance at December 31, 2006Trial Balance at December 31, 2006

CRAccum. amortization 46,510Accounts payable 80,055Wages payable 11,425Sales and other taxes payable 14,660Bank loan payable 27,590Share capital contributed 66,710Retained earnings 25,715Revenue 144,770

417,435


Tanya’s Footwear Ltd.Tanya’s Footwear Ltd.Income Statement for the Year Ended December 31, 2006Income Statement for the Year Ended December 31, 2006

Revenue $144,770


Wages

Expenses: Cost of goods sold $22,750 Selling and administration 61,965 Amortization 6,000

3,500 94,215Income before income tax $50,555


Closing Entry- Tanya’sClosing Entry- Tanya’sDR Revenue 144,770

CR Cost of goods sold expense 22,750CR S & A expenses 61,965CR Amortization expense 6,000CR Income tax expense 14,660CR Wage Expense 3,500CR Retained earnings (the net income) 35,895

Retained earnings, beginning of year $29,165Add net income for the year

Deduct dividends declared during the year 3,450Retained earnings, end of year $61,610

Tanya’s Footwear Ltd.Statement of Retained Earnings

For the Year Ended December 31, 2006

35,895


Tanya’s Footwear Ltd.Tanya’s Footwear Ltd.Balance Sheet as at December 31, 2006Balance Sheet as at December 31, 2006

AssetsCurrent assets: Cash & ST investments $37,540 Accounts receivable 70,240 Unsold inventory 96,490 Supplies 2,000 Prepaid expenses 6,400

$212,670 Non-current assets: Buildings $95,890 Less: Accum. amortization (46,510)

$49,380

$262,050

Liabilities and Shareholders' EquityCurrent liabilities: Accounts payable $80,055 Wages payable 11,425 Sales and other taxes payable 14,660

$106,140 Non-current liabilities: Bank loan payable 27,590

$133,730 Shareholders' equity: Share capital contributed $66,710 Retained earnings 61,610

$128,320 $262,050

Financialstatements

areprepared

Accountsare

adjusted

Posting toaccounts(ledger)

Adjusting entries do not normally involve cash. Their purpose is to augment the transaction-based figures, to

add to the story told by the transactional records. They implement accrual accounting.

Transactionsare

recorded(journalized)

ongoingeventsin the world

AdjustmentsAdjustments


Why are Adjustments Needed?Why are Adjustments Needed?

For correction of errors.

To overcome limitations of transactional base (implementation of routine accruals). These include revenues earned but not yet collected, expenses incurred but not yet paid, and amortization of assets.

To recognize non-routine events or estimates needed to bring the financial statements in line. An example is the “writing down” of assets whose economic value has been impaired.


How are they Done?How are they Done?

Adjustments are completed in the journal entry format as we have already seen (Debits = Credits).

The key is to judge whether an adjustment is needed. Is the adjustment appropriate given the situation?


What Accrual Accounting Adjustments DoWhat Accrual Accounting Adjustments Do

Accrual adjustments affect both balance sheet (assets and liabilities) and income statement (revenues and expenses)

There are four kinds of accrual accounting connections:

Balance Sheet Income Statement

Assets

Liabilities

Equity

Revenue

Expenses

Net Income


Assets

Liabilities

Equity

Revenue

Expenses

Net Income

1)Assets and Revenues,

2)Assets and Expenses,

3)Liabilities and Revenues, and

4)Liabilities and Expenses.


Assets

Liabilities

Equity

Revenue

Expenses

Net Income

The resulting net income goes into equity (retained earnings), completing the articulation of the

statements.

ArticulationArticulation


Pelforth Retail IncPelforth Retail Inc..Preliminary Trial BalancePreliminary Trial Balance

DR Cash 23,000Accounts receivable 78,000Inventories 216,000Prepaid expenses 6,000Land 80,000Building 240,000Furniture and fixtures 110,000Investment in Reddy Ware Corp. 60,000Cost of goods sold expense 409,000Operating expenses 114,000Amortization expense 35,000Interest expense 18,000Income tax expense 11,000

1,400,000


Pelforth Retail Inc.Pelforth Retail Inc.Preliminary Trial BalancePreliminary Trial Balance

CRAccumulated amortization 180,000Bank loan 70,000Accounts payable 112,000Mortgage payable 150,000Share capital 75,000Retained earnings (prior to closing) 193,000Revenue 620,000

1,400,000


1. To reduce prepaid expenses from $6,000 to $4,000DR Operating expenses 2,000 CR Prepaid expenses 2,000

2. To write the investment down to market of $25,000DR Loss on investment (expense) 35,000 CR Investment in Reddy Ware 35,000

3. To record estimated accrued mortgage & bank interestDR Interest expense 2,000 CR Accrued interest liability 2,000

Journal Entries- PelforthJournal Entries- Pelforth

4. To recognize revenue earned on special contractsDR Accounts receivable 15,000 CR Revenue 15,000


5. To recognize the COGS for entry (4)DR Cost of goods sold expense 7,000 CR Inventories 7,000

6. To record estimated warranty expense arising this yearDR Warranty expense 3,000 CR Warranty liability 3,000

7. To write off a receivable that will never be collectedDR Bad debt expense 1,000 CR Accounts receivable 1,000

Journal Entries- PelforthJournal Entries- Pelforth

8. To reduce tax expense and record estimated refundDR Income tax receivable 8,000 CR Income tax expense 8,000


Pelforth Retail Inc.Pelforth Retail Inc.Adjusted Year-End Trial BalanceAdjusted Year-End Trial Balance

DRCash 23,000Accounts receivable 92,000Income tax refund receivable 8,000Inventories 209,000Prepaid expenses 4,000Land 80,000Building 240,000Furniture and fixtures 110,000Investment in Reddy Ware Corp. 25,000Cost of goods sold expense 416,000Operating expenses 116,000Amortization expense 35,000Bad debts expense 1,000Warranty expense 3,000Interest expense 20,000Loss on investment 35,000Income tax expense 3,000

1,420,000


Pelforth Retail Inc.Pelforth Retail Inc.Adjusted Year-End Trial BalanceAdjusted Year-End Trial Balance

CRAccumulated amortization 180,000Bank loan 70,000Accounts payable 112,000Accrued interest 2,000Estimated warranty liability 3,000Mortgage payable 150,000Share capital 75,000Retained earnings (prior to closing) 193,000Revenue 635,000

1,420,000


Pelforth Retail Inc.Pelforth Retail Inc.Year-End Income StatementYear-End Income Statement

Revenue $635,000Expenses: Cost of goods sold $416,000 Operating 116,000 Amortization 35,000 Bad debts 1,000 Warranty 3,000 571,000

Other expenses: Interest $20,000 Loss on investment 35,000 55,000

Income tax 3,000

Operating income $64,000

Income before income tax $9,000

Net income $6,000

Closing Entry- PelforthClosing Entry- PelforthDR Revenue 635,000

CR Cost of goods sold 416,000CR Amortization expense 35,000CR Operating expenses 116,000CR Income tax expense 3,000CR Bad debt expense 1,000CR Warranty expense 3,000CR Interest expense 20,000CR Loss on investment 35,000CR Retained earnings (the net income) 6,000

Retained earnings, beginning $193,000Add net income for the yearRetained earnings, ending $199,000

6,000

Retained Earnings Statement


Pelforth Retail Inc.Pelforth Retail Inc.Balance Sheet at Year-EndBalance Sheet at Year-End

(180,000)

AssetsCurrent assets: Cash $23,000 Accounts receivable 92,000 Income tax refund receivable 8,000 Inventories 209,000 Prepaid expenses 4,000

$336,000Non-current assets:Investment in Reddy Ware Corp. $25,000Land 80,000Building 240,000Furniture and fixtures 110,000Accumulated amortization

$275,000$611,000

Liabilities and Shareholders' EquityCurrent liabilities: Accounts payable $112,000 Accrued interest 2,000 Estimated warranty liability 3,000 Bank loan 70,000

$187,000Non-current liabilities: Mortgage payable 150,000

$337,000Shareholders' equity: Share capital $75,000 Retained earnings 199,000

$274,000

$611,000


Kim’s Sporting GoodsKim’s Sporting GoodsPreliminary Trial Balance at August 31, 2006Preliminary Trial Balance at August 31, 2006

DR CRCash 17,000Accounts receivable 10,400Prepaid expenses 8,800Inventories 21,600Store equipment 20,900Accum. amortization 2,700Accounts payable 7,800Bank loan 4,600Share capital contributed 18,300Retained earnings 12,300Revenue 305,000Cost of goods sold expense 216,000SG & A expenses 56,000

350,700 350,700


Journal Entries- Kim’s Sporting GoodsJournal Entries- Kim’s Sporting Goods

1. Write off a receivable that will never be collectedDR SG & A expenses (Bad debt expense) 2,200

CR Accounts receivable 2,200

2. Several items in the store were stolen and will never be recoveredDR SG & A expenses (Loss on theft

of inventory) 5,000 CR Inventories 5,000



3. Recognize used-up portion of prepaidsDR SG & A expenses 1,100

CR Prepaid expenses 1,100

4. Recognize uncollected revenue mistakenly not recordedDR Accounts receivable 6,000 CR Revenue 6,000(Assume the COGS for this revenue was already recorded.)



5. Recognition of amortization for the yearDR Amortization expense 1,320

CR Accum. amortization 1,320

6. To estimate the income tax for the yearDR Income tax expense 5,200 CR Income tax payable 5,200



7. Record dividend declared that is to be paid laterDR Retained earnings 5,500

CR Dividends payable 5,500

8. To estimate the warranty expense for the yearDR SG & A expenses (warranty expense) 3,200 CR Estimated warranty liability 3,200

Kim’s Sporting GoodsKim’s Sporting GoodsAdjusted Trial Balance at August 31, 2006Adjusted Trial Balance at August 31, 2006

DR CRCash 17,000Accounts receivable 14,200Prepaid expenses 7,700Inventories 16,600Store equipment 20,900Accum. amortization 4,020Accounts payable 7,800Bank loan 4,600Share capital contributed 18,300Retained earnings 6,800Revenue 311,000Cost of goods sold expense 216,000SG & A expenses 67,500Amortization expense 1,320Income tax expense 5,200Income tax payable 5,200Dividends payable 5,500Estimated warranty liability 3,200

366,420 366,420


Kim’s Sporting GoodsKim’s Sporting GoodsIncome Statement for the Year-Ended August 31, 2006Income Statement for the Year-Ended August 31, 2006

Revenue $311,000


Expenses: Cost of goods sold $216,000 SG & A 67,500 Amortization 1,320 284,820Income before income tax $26,180


Closing Entry- Kim’s Sporting GoodsClosing Entry- Kim’s Sporting Goods

DR Revenue 311,000CR SG & A expenses 67,500CR Amortization expense 1,320CR Income tax expense 5,200CR Cost of goods sold expense 216,000CR Retained earnings (the net income) 20,980

Retained earnings, beginning of year $12,300Add net income for the year

Deduct dividends declared during the year 5,500Retained earnings, end of year $27,780

Kim’s Sporting GoodsStatement of Retained Earnings

For the Year Ended August 31, 2006

20,980


Kim’s Sporting GoodsKim’s Sporting GoodsBalance Sheet as at August 31, 2006Balance Sheet as at August 31, 2006

AssetsCurrent assets: Cash $17,000 Accounts receivable 14,200 Prepaid expenses 7,700 Inventories 16,600

$55,500

Non-current assets:Store equipment $20,900 Accumulated amortization (4,020)

$16,880

$72,380

Liabilities and Shareholders' EquityCurrent liabilities: Accounts payable $7,800 Estimated warranty liability 3,200 Dividends payable 5,500 Income tax payable 5,200

$21,700 Non-current liabilities: Bank loan 4,600

$26,300 Shareholders' equity: Share capital $18,300 Retained earnings 27,780

$46,080 $72,380


Managers, Investors, and Managing EarningsManagers, Investors, and Managing Earnings

Earnings are important

Earnings announcements

Income smoothing

The Big Bath


Earnings ManagementEarnings Management

What is it? A company chooses accounting methods that alter

the size or interpretation of its net income

Why does it happen? Users of financial information place great

importance on a company’s earnings or net income Increasing pressure on managers to “perform” and

meet expectations of analysts and the stock markets


Income SmoothingIncome Smoothing

Managers create stable income numbers from year to year

Creates less variability in performance

SmoothedVariable


““Big Bath”Big Bath”

In a bad year, a company chooses accounting methods to make a loss look even worse

Eliminates all the bad news at one time and helps future earnings

Could occur after a new CEO takes over Examples include large restructuring

charges or investment write-downs


Write-offs of Consolidated GoodwillWrite-offs of Consolidated Goodwill

A type of “Big Bath” strategy Goodwill is an asset created when two companies

merge and the price paid for the company is more than the value of its assets

If this value has declined, the value of the goodwill is written down or written off to expense

**the write-down or write-off may dramatically reduce net income but has no effect on cash

AOL Time Warner First Quarter 2001 incurred a loss of $54.2 billion after taking a goodwill write-down


EBITDA & Pro Forma EarningsEBITDA & Pro Forma Earnings

Earnings before interest, tax, depreciation and amortization (EBITDA)The company reports only operating income that

leaves out large expenses and one-time charges such as high amortization expenses on large assets

Shows a clearer picture of the company’s operating performance(??)

Pro forma earningsFocus on how the company will supposedly

perform in the future


Stock Option CompensationStock Option Compensation

Options give an individual the right to buy or sell a stock at a certain price

Companies offer this type of compensation to executives

Currently, it seldom has to be reported as an expense on the income statement

Allows companies to give large potential payoffs to execs or employees without reducing net income

1 © 2007 by nelson, a division of thomson canada limited. chapter 3: measuring and evaluating...

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