Chapter 4: The Income Statement, the Retained Earnings ...



340aclass8

September 17, 2002

For next time: Readings Chapter 5

Homework: E5-4,7

Remember Suppl HW due on 9/26, 50 pt. quiz 9/24!

Today:

Extraordinary Items

M&Mco

Cumulative Changes and changes in estimate

EPS

EXTRAORDINARY ITEMS:

Extraordinary items are, by definition, MATERIAL events that are UNUSUAL AND

INFREQUENT. This is a very high threshhold. The book gives you good examples of things that would and would not be extraordinary events. (page 127,128)

In class we talked about UAL for the third quarter ended 9/30/01 to see how 9/11 losses were recorded. Items that are Infrequent OR Unusual show up above the continuing operations line but broken out separately from other expenses (examples are Special Charges or Restructuring Charges).

ex. Suppose you have an extraordinary loss of $4,000,000. Your tax rate is 40%. What would you report on the income statement?

The tax effect is $4,000,000 * .40 = $1,600,000. The Extraordinary Loss after tax is $4,000,000 - $1,600,000 or $2,400,000. So the income statement would show:

Extraordinary loss, net of tax savings of $1,600,000 $2,400,000

Are there any exceptions to the unusual and infrequent rule?

SOME EXCEPTIONS: Gains and losses from early extinguishment of debt , AND tax benefits of loss carryforwards are always classified as extraordinary items and reported separately.

DISCONTINUED OPERATIONS:

Discontinued operations refers to any segment of a business that stands alone as a separate line of business or class of customer that is disposed of or abandoned by the company. When such a decision is made by the company, any gains or losses from the disposal are reported separately (net of tax). To qualify for discontinued operations treatment, the assets, results, and activities of the segment must be CLEARLY DISTINGUISHABLE, BOTH PHYSICALLY AND OPERATIONALLY from the company's other assets, results and activities.

This sounds easy enough but defining a business segment can be kind of tricky (look at page 130 to see what might make some of the items fall short)

What is reported separately regarding the discontinued operations? 2 pieces (NET OF TAXES)

1. Operating results since the beginning of the year through the "measurement date" - this is reported as "Gain or loss from Discontinued Operations"

AND

2. Any gain or loss on the actual disposal (if you sold the segment, you might have a gain or loss), including any operating income or loss from the "measurement date" through the "disposal date" - this is reported as "Gain or loss on Disposal of business segment".

The "DATES"

"measurement date" - the date that the company formally commits itself to dispose of the segment. The FORMAL commitment requires that the company be able to reasonably describe the following:

1. identification of specific assets to be disposed of

2. how the disposal will take place (method)

3. how long the disposal will take

4. active program to find a buyer, if applicable,

5. estimated results of the segment from measurement date to the date of disposal

6. Estimated proceeds or salvage to be realized by the disposal

"disposal date" - is one of the following three dates:

1. the closing date of the sale of the segment,

2. the date operations cease,

3. the date of significant changes resulting from technological improvements

M&Mco in-class example of reporting discontinued operations (we have to worry about the "dates" and the recognition of gains or losses) do in-class example with equal dates, same year dates, and cross-year dates.

HOW DO WE FIGURE THE AMOUNT FOR EACH LINE (Gain or loss from discontinued operations AND Gain or loss on disposal of business segment)?

The lowdown on the reporting for discontinued operations in 3 easy steps:

1. Figure the operating results from the beginning of the year through the measurement date. Then find the tax effect and report the net amount as the gain or loss from discontinued operations

2. Figure the actual gain or loss on sale of the assets. Find the tax effect. Report the net amount as part of the gain or loss on the disposal.

3. Figure the operating results between the measurement date and the disposal date. Find the tax effect, and the net amount is included as gain or loss on disposal.

(Draw a time line) - it helps! The timing of the disposal date is what complicates things.

If measurement date = disposal date, this is easy. (Steps 1 and 2 only)

If disposal date is after measurement date but before the end of the year, then step 3 comes into play.

If disposal date is in another fiscal year, then step 3 comes into play AND any net expected, estimable losses in the future years must be recognized and included in the year of the "measurement date".*

*If you want a more detailed example of this, look at the discussion on page 135 of your text. The Case 1,2,3 examples outline the situation where gains and losses are recognized.

Here is the end of the example that we had on the board today.

Case 3: Disposal date is February 29, 2000 and an estimated pretax loss of $6000 is expected for the period from 1/1 through 2/29/2000.

Entries:

Disposal of assets:

(A() Special Receivable $1,900,000

(OE() Loss on Disposal of mag. 100,000

(A() Assets - mag. division $2,000,000

To record loss on disposal (we debit a RECEIVABLE instead of CASH since the actual disposal isn't until February of next year)

(OE() Revenues - magazine 15,000

(OE() Loss on disposal 10,000

(OE() Expenses - magazine 5,000

To recognize income from Oct - Dec for magazine division. (this is the same entry we made in CASE 2)

(This time period is called the "phase-out period".)

PLUS Operating loss expected for next year:

(E)Loss on disposal of segment $6000

(L) Accrued loss on segment operations $6000

To accrue the estimated loss on disposal (WE have to recognize this loss now!)

(This is also part of the "phase-out period".)

(Conservatism makes us recognize losses as soon as they are reasonably estimable and probable.)

Income statement:

1999 1998

Income from continuing operations after taxes $XXX $XXX

Discontinued operations:

Income from discontinued operations, net of

taxes of $10,500 in 1999 and 15,000 in 1998 24,500 35,000

Gain(loss) from disposal of disc. operations,

net of income tax:

Income during phaseout, net of tax of 1,200 2,800

Loss on sale of assets, net of tax($30,000) (70,000) (67,200)

Net income $XXXX $XXXX

Before tax: -100,000 + 10,000 - 6,000 = -96,000

Tax: (96000) * 30% = (28,800) tax savings

Net of tax amount : -96,000 + 28,800 = -67,200 see above.

Case 4: expected gain. Even the textbook authors got sick of this by this point! I will not require you to be able to go through Case 4 on an exam.

Some things to think about :

Again, think about predicting the future profitability of the company. Would you want to include the results from discontinued operations? No, since you know with certainty that these operations will not be part of the company's future.

Your textbook authors report that companies tend to err on the side of calling things Discontinued Operations when in fact the situation might not meet the definition. The authors state that they like this tendency because it gives full disclosure. What might a cynic say about this tendency?

Not sure? Think about it this way:

Suppose you were the manager and your bonus was based upon Income from Continuing Operations. Where would you want to report losses from a discontinued line of business? Why do you think the FASB is so picky about the definition of business segment for reporting discontinued operations?

IMPORTANT:!!!!!! We didn't get a chance to talk about this in class but you are responsible for this change in accounting principle and change in accounting estimate stuff. Ask me any questions you have. You will see it later!

CHANGE IN ACCOUNTING PRINCIPLE

This means a change from one generally accepted accounting method to another generally accepted accounting method. This is not the same as changing an estimate about future losses, useful lives, etc. The change is recorded with a catch-up entry that recognizes the difference between the old method and the new method from inception to date. EX. The initial recording of post-retirement employee benefits. The catch up amount is reported, net of tax, on usually the last separate line of the income statement:

Cumulative change in accounting principle, net of tax effect $xxxxx

CHANGE IN ACCOUNTING ESTIMATE

This means that you have changed your best guess about a reported value – it may be that you change the amount of an estimated loss or you change the useful life of an asset or you change the salvage value of an asset. This type of change is handled on a prospective basis – meaning that you don’t go back and restate or “catch up” for the revised estimate – you simply use the new estimate going forward.

>Companies are required to DISCLOSE this type of change in their FOOTNOTES

Think about this: In our case from the beginning of the semester, when AOL decided to call its free disk marketing strategy a marketing expense rather than an asset, the change was reported as a change in accounting estimate. What "estimate" did AOL change? Do you think this was a change in estimate or a change in principle? Why do you suppose AOL would NOT want to call this change a change in principle?

Thinking of predicting the future again, how might the change in principle mess you up, if it was not recorded separately? (It would lead you to over or under-estimate expenses or revenues)

Now we have talked about the generic rules for reporting income. What is the most important line in the income statement for analysts? for managers? Usually the focus of these two groups is on the "Income from continuing operations"

-for analysts, this gives them the best idea of what kind of earnings they might expect in the future from the continuing operations.

-for managers, this is usually the line that the compensation /performance bonus plan is based on.

What are some non-GAAP income measures that firms report? How do these usually compare to GAAP measures? Think about the Pro-forma and EBITDA results you looked up on the web.

Here are some good articles that you might want to read about pro-forma earnings.





IMPORTANT:

The three separate item lines are usually carefully studied by analysts and investors and the SEC because there is a great temptation for managers to record expenses and losses below the continuing operation line and to record revenues and gains above the line.

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