A Role of The Financial Management along with Company’s Goals

A role of the financial management

Financial Management is an interesting subject to learn, a lot of news about growth, takeovers and corporate restructuring. To understand all about this issue, we have to know about financial management and financial markets. In general, many companies face the same problems, for example, a company engaged in the manufacture of kitchen appliances need the equipments to process raw materials into finished goods in the form of kitchen appliances. The company has to build a factory to store equipments and raw materials. They also need workers to perform the process of making and selling the products. When the production process takes place, firms must have a supply of raw materials, works in process and finished goods. The company also needs funds to conduct activities. Companies must pay employees without having to wait for the proceeds in cash. The company also has to keep accounts receivable, when the company grows bigger the more funds will be needed to support the activities.

The example of recent situation is a real picture of the problems faced by the company, financing problems and some decisions should be taken by a financing manager of the corporate.

Central tasks and responsibilities of a financial manager

As a financial manager, he or she must be able to deal with

• Selection of products and markets for the company.

• Selection of strategies that will be used to conduct research, investment, production techniques, sales and   promotions.

• Selection, training and motivation on employee.

• Efforts to raise funds with low cost and efficient ways.

• A series of adjustment measures on the business environment and level of competition.

Because of the tasks to be performed by a financial manager, he or she should do with

1. Financial analysis of the result related with the decisions which made.

2. Do any analysis on funding needs to be achieved and the potensial sales volume by the company.

3. Do some efforts to raise for funds in accordance with the level of demand needed by the company.

4. Do any analysis on balance sheets and income statements, finding the way of cost control and ideas in making price decision of products or services sold.

5. Do any analysis on cash flow statements to determine the sources and uses of funds.

Financial functions

Generally the financial functions are making investment decisions, financing decisions and dividend distribution to investors for the use of their funds. Funds have been collected either from internal or external companies used to support all business activities should be able to generate an attractive return or exchange of yield. This is a real thing and a very common way in the organization of business firms, government and nonprofit organizations.

The things that should be achieved by a financial manager as the main objective of their works

1. Do plans to acquire and the use of funds to maximize the value of the organization.
2. Everything which be done must focus on investment and financing decisions or relate with it. Generally the successful companies have many experiences about the ways to increase sales of products or services and to raise funds from investors.
3. Do any collaboration with other managers so the company can operate more efficiently. For example, each marketing decisions will impact to sales, investment needs, the availability of funds, inventory policies and the use of production capacity.
4. Do something to connect companies with the money market and capital market, where firms obtain funds and trade securities.

The functions and duties of financial managers directly deal with the major company's decisions and they effect on value of the firms. As a Financial Director or Chief Financial Officer (CFO), he or she has a high level position within the organizational structure of the company and an important role on each decision which he made. CFO interacts with senior officials and other functional fields in the organization, he or she must be able to deliver and communicate to all divisions about the financial implications concerned with the decisions which he made. CFO also takes responsible for all activities of the treasurer and controller which performed.

The differences of duties and responsibilities by a treasurer and a controller.

According to the finance function within the organization, there are differences of duties and responsibilities between a treasurer and a controller

1. A treasurer is a person who has responsibles for the acquisition and the use of funds. A treasurer shall maintain a relationship between the company with the bank and having  jobs with managing credit, insurance funds and pension funds.
2. A controller or accounting or administration is a person who has responsibles for accounting issues, financial statement reporting and control, procurement and cash management including daily cash flow position reporting and the position of working capital, cash budgeting and cash flow statement as cash reserves.

A controller or accounting has to keep records on company's financial statements including budget preparation, payroll, tax and internal audit.

Some companies use the company secretary not only to attend and record on every topic of top management’s meeting but also to manage each listing of shares and bonds owned by the company. In this case the companies secretaries are required to understand on various rules about stocks issues and bonds.

For financial managers who are proved active and have the ability in setting direction and policy of the company and able to pass through various levels of difficulty due to decisions that made ​​by the top management level, likely toward the top position in the company as its CEO.

There is also some companies that use financial committee consist of people with different various of backgrounds and abilities to formulate policies and preparing decisions for the company relate with financing issues. This finance committee is determining whether a company will use finance resources from within or outside the company for its operations. During this determining process, the finance committee concern with the economic conditions such as interest rates and industry factors such as the impact of changes in commodity prices and the trend of stock price due to market perceptions on current business situations and conditions and market expectations of the future corporate performance.

A very simple failure managing indicator of a corporate with its financial management is presented by the company's stock price which is likely to decline. In the United States, financial management goal is to maximize the value of company’s stock while having a conflict of interest between the owners of the company with the provider of the fund as a creditor. In Japan, financial management objectives are not only maximizing the value of company’s shares, but also try to capture the largest market share for the enterprise products because with the largest market share the company will be able to keep with the long-term profitability. In Europe, the goal of financial management have some kind of combination with increasing on social welfare instead of just as in the United States and Japan.

For example, a company whose activities are using 50%  common stock and 50% bond loans with a rate of 10%. When the company gets earnings, all bondholders will enjoy the results of 10% but somehow if the company gets greater success, the value of its common stocks issued by the company will obtain a tremendous increasing but the value of bonds still remain unaffected. Conversely, if the company is getting financial difficulties that cause irritate on the repayment of debt, all bondholders will get precedence right while the value of the company's stock will decline.

Based on the example, the value of common stocks become an indicator to measure the level of success of a company in conducting on its activity. A company that perform better than other companies would enjoy a higher increasing in its stock value and more convenience in obtaining of new funds when needed.

The objective of maximizing the value of stocks does not mean to sacrifice the interests of bondholders by diverting the initial activity to become an investment activity that contains more risk. If a company succeeds in investing, the shareholders will enjoy a huge of advantages but the result does not bring any impact to the bondholders. Conversely, if such investment with a higher risk is fail then the interests of the bondholders would be threatened even the bondholders as creditors have a priority right to obtain a return on funds. Therefore, as a guarantee that companies will not and must not alter the initial of company’s activitiy arbitrarily, the company is required to pay a higher interest rate to bondholders as a compensation for the changes of policies that negatively impact to the investors.

Maximizing the value of stocks or to maximize the value has a broader meaning than just maximizing on profits.

·         Maximizing the value means to consider the influence of time on value for money. Funds which received today is more valuable than which is received someday in the future.

·         Maximizing the value also means to consider the risks of revenue streams. The rate of return on securities issued by some government-owned companies have a lower risk of default than the rate of return on securities issued by private-owned companies.

Improvement of social welfare is a social responsibility which are included in the financial management objectives.

To maximize the value of company's stocks requires a capable management performance to run the business very well however to maximize the corporate’s value can be done through the creation of the new products which are more efficient and innovative through the use of many kinds of new technologies and bring the better impact on increasing volume of employment. Companies that have successfully in maximizing on the value of the company are able to produce good quality and useful products in large quantities.

Social responsibility can be manifested by the company through the efforts which can bring more healthy environment by reducing on pollution to a minimum state. All the waste should be processed into a harmless condition. A corporate social responsibility is not only going with a waste problem but also have to produce the products that are safe for daily consumption. The safety work environment of the plant with a zero level in accidents is a part of corporate social responsibility objectives. Similarly, the company policies and the impact of corporate activities and the efforts to enhance the welfare of the community around the business location are part of a social responsibility which have to be achieved by financial management.

Profitability and risk factors.

Profitability and risk are the most influence factors upon the value of the company. The most important thing that should be decided by financial management concerned with the corporate profitability and risk is choosing on which industries should be run by the company. Second, to select on large or small scale of business activities that will be run by the company. Third, which rate of growth that the company should obtain. Fourth, which machines are needed and how many machines should be provided to support all of the activities. Last, the financial management should decide about how much debt will be used to maintain on company's liquidity and business activities.

A cash position can be used to reduce the level of risk faced by the company but the excess supply of cash that does not give the results could potentially disrupt the company's profitability.

Increasing in debt will impact on rate of return and the risk for the company although it  gives more profitability for shareholders' capital. To overcome this problem, the financial manager should be able to find a balance point or the trade-off between the level of risk with the level of the most optimal return on capital for shareholders.

In addition of considering the risk and return, other things that influence on financial management is the increasing of the rate of inflation nor a hyper inflation state. That kind of inflation brings some influential impact on financial.

a)   The problems that occur in accounting as a result of an increasing in the rate of inflation nor a hyper inflation state

Increasing the rate of inflation affects the reporting of earnings listed in the income statements. An increasing in profits that are listed in the income statement as a result of the increasing value of sales revenue due to inflation while the value of inventories is still using the numbers before the occurrence of inflation. The cash flow is decreasing to the lower condition, especially when companies have to make some purchasings again with an expensive price to replenish inventories.

Besides the increasing in profits due to an inflation, the calculation of depreciation costs which had been made is useless because the amount of depreciation can not be used to carry any equipments and replace with a newer machine nor equipments, because the cost of equipments and the price of machines has increased due to inflation. As a result, reported earnings in the income statement become more higher because the value of inventories and depreciation costs are low because they are using the values before the inflation occur.

Consequently of reporting on high profit in the income statement, the payment of income tax which made ​​by the company becomes higher and the company’s cash flow is decreasing. If the company plans to pay dividends and do some purchasings for any  machines during the inflation time, then it will bring more severe condition on financial.

b)  The problems that occur in planning as a result of an increasing in the rate of inflation nor a hyper inflation state

Each business activity is preceded by a long-term planning. For example, to set up  a factory always precedes with an analysis of costs and benefits projection for the activity which to be selected. The age of business activity, economic conditions and levels of competition will be considered along with the analysis process. In such conditions where an increasing in the rate of inflation nor a hyper inflation state is happening, a plan that has been made is difficult to be implemented because the price of raw materials and wages is increasing very rapidly.

c)   The problems that occur in demand for capital as a result of an increasing in the rate of inflation nor a hyper inflation state

An inflation will cause increase to a demand for the capital needed to run its business activity in a given volume and time period. A purchasing activity to replenish inventory that has sold out or used up will cost more expensive due to the rising prices of goods. Every expenditure needs to perform maintenance and repairs on tools and production machinery is also increasing due to the rising prices of equipments, spare parts and wages. While financial managers are looking for any additional capital as needed, the government tried to control the rate of inflation by limiting the funds circulating in the community through some restrictions rules for all lending activities. Because the funds which circulate in the community is less and less while the number of requests for funds or the demand for capital is increasing, so the lending rates is increasing too.

d)   The problems towards the interest rates as a result of an increasing in the rate of inflation nor a hyper inflation state

The interest rate listed on each securities paper is an actual interest rate which used for the normal economic conditions, not available for the economic condition with a hyper inflation state.

The prevailing interest rate in the money market is the nominal interest rate, which consists of the actual interest rate plus the inflation index or the inflation premium. Inflation index or the inflation premium is a long-term inflation rate expected by the government for a certain period of time. Due to an increase in the rate of inflation results in high costs to obtain funds for the government, businesses and individuals.

e)   The problems towards the interest rates of bonds as a result of an increasing in the rate of inflation nor a hyper inflation state

If the interest rates is increasing because of an increasing in the rate of inflation, then the prices of long-term bonds will decline. To overcome the losses due to impairment of the capital, then the lender will make some changes to the interest rate of bonds. Normally, interest rates of bonds are fixed rates, due to an increase in the rate of inflation, the interest rates of bonds will follow to the volatile movement of interest rates or follow the movement of bonds indexes.

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Irregular Items Related to The Income Statements

Whether we are using a single step income statement nor a multiple step income statement, flexibility in the presentation of the components of the income statement data has been permitted. However there are two important areas that should be included relate to income and how certain unusual or irregular items should be reported.

Unusual or irregular items or irregular transactions encompasses transactions and other events that are derived from developments outside the normal operations of the business. There are several concepts concern with this unusual or irregular items. Should irregular gains and losses and corrections of revenues and expenses of prior years be closed directly to retained earnings and not be reported in the income statement ? Or should they first be presented in the income statement and then carried to retained earnings along with the net income or loss for the period ?

I.   Current Operating Performance Concept

According to this concept, the net income should show only the regular, recurring earnings of the business. Irregular gains and losses do not reflect an enterprise’s future earning power. Therefore irregular gains and losses should not be included in computing net income but should be carried directly to retained earnings as special items. However many readers are not trained to differentiate between regular and irregular items, so it would be confused if such items were included in computing net income.

II.   All Inclusive Concept

According to this concept, irregular items should be included in net income because any gain or loss by the concern whether directly or indirectly related to operation will contribute to its long run profitability. Irregular gains and losses can be separated from regular operations to arrive at income from operations but income for the year should include all transactions.

When judgment is allowed to determine irregular items, a danger of manipulating income data will arise. A recent study noted that management sometimes reports unusual losses as non-recurring but reports unusual gains as part of regular income. This kind of presenting misleading information by managements to investors and creditors just to impress that they are not seriously in troubled.

For example, a company directly wrote off $20 million as losses to retained earnings. By doing this, the company enables to report earning per share of $1.13 . If the company write off $20 million as losses to expense, the company would have reported a loss of 87 cents per share. It could be more advantage for a company to run one time losses through retained earnings but gains through income.

According to all inclusive concept this flexibility should not be allowed because it leads to poor financial reporting practices and we realize that poor accounting practices drive out good ones.

III.   A Modified All Inclusive Concept

According to this concept, a number of subsequent pronouncements require irregular items to be highlighted so that the reader of financial statements can determine the long run earning power of the enterprise. There are five irregular items to be highlighted

• Discontinued operations
• Extraordinary items
• Unusual gains and losses
• Changes in accounting principle
• Changes in estimates

Discontinued operations

The disposal of a business or a product line is one of the most common types of irregular items. A separate category in an income statement for the gain or loss from disposal of a segment of a business must be provided. The result of operations of a segment that has been or will be disposed of is reported with the gain or loss on disposal, separately from continuing operations. The effects of discontinued operations in income statements are shown after continuing operations but before extraordinary items.

To illustrate, a company decides to discontinue its electronics division. During the current year, the electronic division loss $100,000 (net of tax) and was sold at the end of the year at a loss $160,000 (net of tax), so the total loss of discontinued operations will be $260,000 ($100,000 + $160,000). Income from continuing operations $23 million. As a result, net income on the current year’s income statement was $22,740,000 ($23 million - $260,000)

The phrase “INCOME FROM CONTINUING OPERATIONS” is only used when gains or losses on discontinued operations occur. To qualify as discontinued operations, the assets, results of operations and activities of a segment of a business must be clearly distinguishable physically and operationally from the other assets, results of operations and activities of the entity.

Disposal of assets incidental to the evolution of the entity’s business is not considered to be disposal of a segment of the business. Disposal that do not qualify as disposal of segment of a business as follow

• Disposal of part of a line of business.
• Shifting production or marketing activities for a particular line of business from one location to another.
• Phasing out of a product line or class of service.
• Other changes due to a technological improvement. 

Examples that qualify as a disposal of a segment of a business

• Sale by a meat packing company of a 60% interest in a professional football team.
• Sale by a communications company of all of its radio stations but none of its television stations or publishing houses.

 

Conversely, examples that would not qualify as a disposal of a segment of a business

• Discontinuance by a woman shoes manufacturer of its operations in Taiwan but not elsewhere.
• Sale by a diversified company of one furniture-manufacturing subsidiary but not all furniture manufacturing subsidiaries.

Judgment in defining a disposal of a segment of a business must be exercised because the criteria are difficult to apply in some cases.

Extraordinary items

Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence, or in other words it is defined as non-recurring material items that differ significantly from the entity’s typical business activities.

To classify an event or transaction as an extraordinary item, both the two following criteria must be met

a)    Unusual nature

Event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to the ordinary and typical activities of the entity.

b)    Infrequency of occurrence

Event or transaction should be of a type that would not be expected to recur in the foreseeable future

According to Accounting Principle Board (APB), the following gains and losses that are not extraordinary items

(A).  Write-down or write-off of receivables, inventories, equipment leased to others,   deferred research and development (R & D) costs, other intangible assets.

(B).  Gains or losses from exchange of foreign currencies including those relating to devaluations and revaluations.

(C).   Gains or losses on disposal of a segment of a business.

(D).   Other gains or losses from sale of property, plant or equipment used in the business.

(E).    Effects of a strike, including those against competitors and suppliers.

(F).    Adjustment of accruals on long term contracts.

Those items listed above are not considered extraordinary because they are usual and may be expected to recur as a consequence of customary and continuing business activities. Gains or losses such as point (A) and point (D) above would be classified as extraordinary if they are unusual and infrequent and they do as a direct result of a major casualty such as an earthquake, an expropriation or a prohibition under a newly enacted law or regulation. Such circumstances meet the criteria of unusual and infrequent.

In determining whether an item is extraordinary, the environment of the entity operates such as

• Industry characteristics.
• Geographic location.
• The nature.
• Extent of governmental regulations

 

is primary importance. The disposal of a business segment at a gain or loss on disposal of a segment of a business, refer to point (C) above which is not an extraordinary item, requires a special accounting treatment.

Material gains and losses from extinguish of debt should be reported as an extraordinary item even though these gains or losses do not meet the normal criteria as mentioned above for extraordinary items. It is often difficult to determine what is extraordinary. Firm guidelines for judging when an item is or is not material have not been established. Some companies judge as extraordinary gains or losses items that accounted for less than 1% of income. If companies face a larger loss is inevitable, they used “big – bath” approach to write-off as much as possible because according to this approach there is not a great distinction between a small loss and a larger one, future statements will still provide a company with a quick earnings injection. Therefore, in making the materiality judgment, extraordinary items should be considered individually. These extraordinary items are to be shown net of taxes in a separate section in the income statement, usually before net income. 

A company presented its extraordinary loss in its income statement. Income before extraordinary item $12,500,000 . The extraordinary item represents the estimated cost of flood loss (net of tax) $1,306,000 (the estimated cost of flood loss $1,374,000 – tax $68,000). Therefore the net income in its income statement $11,194,000 ($12,500,000 - $1,306,000)  

Unusual gains and losses

Financial statement users must carefully examine the financial statements for items that are unusual or infrequent but not both. Items such as write-downs of inventories and gains and losses from fluctuation of foreign exchange are not considered as extraordinary items. These items are sometimes shown with the normal, recurring revenues, costs and expenses. If they are not material in amount, they are combined with other items in the income statement. However, if they are material, they must be disclosed separately, but are shown income (loss) before extraordinary items.

These $18 millions ($9 millions + $7 millions + $2 millions) are examples of unusual items, consist of

• Restructuring charges related to the company’s special voluntary early retirement program and selective job eliminations $9 millions.
• Write-off in the book group due to repositioning of inventory and promotion costs $7 millions.
• Other corporate charges $2 million

 

If company’s revenue $700 millions and operating costs and expenses $710 millions, consist of

• Production and distribution $335 millions.
• Selling and general administrative $340 millions.
• Depreciation and amortizations $17 millions.
• Unusual items as calculated above $18 millions 

Loss from operations will be $10 millions ($710 millions - $700 million) because of unusual items.

In recent years, there is a tendency to report unusual items in a separate section just above “income from operations” before income taxes and extraordinary items, especially when there are multiple unusual items. Unusual gains and losses should be reported in other revenues and gains or other expenses and losses section unless you are instructed to prepare a separate unusual items section.

In dealing with events that are either unusual or non-recurring but not both, companies often reported such transactions on a net of tax basis and prominently displayed the earnings per share effect of these items.

Changes in accounting principle

It is occur frequently in practice because important events or conditions may be difference or uncertain at the statement date. One type of accounting changes contains the rule repeating corrections and adjustments that are made by every business enterprise. Changes in accounting principle would include a change in the method of inventory pricing from FIFO to AVERAGE COST or a change in depreciation from the DOUBLE DECLINING or ACCELERATED to the STRAIGHT LINE METHOD.

Changes in accounting principle are realized by admitting the cumulative result of net income of tax in the current year’s income statement. This amount is based on a retroactive calculation of changing to a new accounting principle. The effect on net income of adopting the new accounting principle should be disclosed as a separate item following extraordinary items in the income statement.

Placement on financial statements, cumulative effect of the change is reflected in the income statement between the captions extraordinary items and net income (shown net of tax).

Changes in estimate (normal, recurring corrections and adjustments)

Estimates are built-in in accounting process. Estimates are made of

• Useful lives and salvage values of depreciable assets.
• Uncollected receivables.
• Inventory obsolescence.
• Number of periods expected to benefit from a particular expenditure.

Not in frequently, as time passes or circumstances changes or as a different information is received, however estimates originally made in straightness must be changed. Such changes in estimates are accounted for in the period of change if they affect only that period or in the period of change and future periods if the change affects both.

To illustrate a change in estimate that effects only the period of change, assume that a company has consistently estimated its bad debt expense at 1% of credit sales. However, the controller determines that the estimate of bad debts for the current year’s credit sales must be revised upward to 2% or double the prior year’s percentage. Using 2% results in a bad debt change will reduce accounts receivable to net realizable value.

The entire change in estimate is included in the current year’s income, no future periods are affected by the change. Changes in estimate are not handled retroactively. Changes in estimate are not considered errors or extraordinary items.

Changes in the realizability of receivables and inventories, changes in estimated lives of equipment and intangible assets, changes in estimated liability for warranty costs, income taxes and salary payments, are examples of changes in estimates.

Placement on financial statements, change in income statement only in the account affected, not shown net of tax.

Discontinued operations of a segment of a business is classified as a separate item in the income statement after continuing operations. The unusual, material, non-recurring items that are significantly different from the typical or customary business activities are shown in a separate section for “Extraordinary Items” below “Discontinued Operations”.

Other items of a material amount that are of an unusual or non-recurring nature and are not considered extraordinary are separately disclosed. The cumulative adjustment that occurs when a change in accounting principles develops is disclosed as a separate item just before net income.

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The Limitations of an Income Statement

As we know that financial news indicate the impact on the value of the enterprise. The statement of income called INCOME STATEMENT or STATEMENT of EARNINGS is the report that measures the success of enterprise operations for a given period of time. The business and community uses this report to determine

#   Profitability

#   Investment value

#   Credit worthiness

This report provides investors and creditors with information that helps them predict the amounts, timing and uncertainty of future cash flows.

The purposes of an income statement

The income statement helps users of the financial statement predict future cash flows in a number of different ways. Investors and creditors can use the information on the income statement to evaluate the past performance of the enterprise. Although success in the past does not mean success in the future but trends may be determined. If a reasonable correlation between past and future performance can be assumed, then predictions of future cash flows can be made.

Income statement helps users determine the risk concerned with level of uncertainty of not achieving particular cash flows among revenues, expenses, gains and losses. Operations are usually the major means by which revenues usually have greater significance then results from nonrecurring activities and events.

Suppose a manufacturing company that specializes in electronic spare-parts reported $20 million of income from continuing operations before taxes. A closer examination of this income revealed that

$8 million of income came from a gain on the sale of stock

$2.6 million represented a gain on the exchange of stock

$3.9 million came from a gain on the sale of stock in its investment portfolio

$3.4 million came from settlement of lawsuits related to patent infringements

The largest revenue $10.5 million comes from patent or royalties on its electronic spare-parts that might not continue because the patent was about to expire. Our point is that income does not tell the whole story because the derived income is at best a rough estimate, the reader of the statement should take care not to give it more significance than it deserves.

According to economists, income as the maximum value of an entity can consume during a period and still be as well off at the end as at the beginning. Any effort to measure how well an entity is at any point in time will prove fruitless unless certain assumptions are developed and applied. Income should measure not only monetary income but also physic income. Physic income is defined as a measure of increase in net wealth arising from quantitative factors. Accountants know that the recognition of such experiences might be useful but the problem of measurement has not been solved. Thus, items that cannot be reliable quantified have been discarded in determining income.

Income numbers are often affected by the accounting methods employed. For example, a company may choose to depreciate its plant assets on an accelerated basis while another company may choose a straight line basis. Assuming all factors are equal, the income of the first company will be lower than the second company event though the companies are same. Thus the quality of earnings of a given enterprise is important. Companies that use liberal or aggressive accounting policies report higher income in the short run. In such cases, we say the quality of the earnings is low. Other companies generate income in the short run as a result of a non-operating or nonrecurring event that is not sustainable over a period of time.

It is permissible to use smooth earnings by creating balance sheet reserves. This reserves are created by reducing income in good years however in less profitable years previous income is retrieved from the reserves to increase the income in the current year.  

There are two ways to calculate net income

I.  Capital Maintenance Approach or Change in Equity Approach

Ending net assets on the year minus beginning net assets on the same year plus dividend declared during the year then deduct with owner’s investments during the year, to get net income for the year.

It takes the net assets or capital values based on historical cost, discounted cash flows, current cost or fair market value and the difference in capital value at two points in time.

Suppose a corporation had beginning net assets $30,000 and $54,000 at the end of the year. During the same year additional owner’s investments $15,000 were made and $3,000 of dividends were declared. Calculation of net income for the period employing the capital maintenance approach is $12,000 ($54,000 - $30,000 + $3,000 - $15,000)

When using this capital maintenance approach, the composition of the income is not evident because the revenue and expense amounts are not presented to the financial statement reader.

II.  Transaction Approach

The alternative procedure measures the basic income related transactions that occur during a period and summarizes them in an income statement called TRANSACTION APPROACH. This approach focuses on the activities that have occurred during a given period. Instead of presenting only a net change, it discloses the components of the change. The transaction approach provides information on the elements of income. According to this approach, income may be classified by

#   Customer

#   Product line or function

#   Operating and nonoperating

#   Continuing and discontinued

#   Regular and irregular

 

It is called “IRREGULAR” if transactions and events are derived from developments outside the normal operations of the business. For example, the sale of investments by an insurance company is part of its irregular operations, whereas in a manufacturing enterprise it is not.

The transaction approach to income measurement requires the use of revenue, expense, loss and gain accounts, without which an income statement cannot be prepared. The distinction between revenues and gains and the distinction between expenses and losses depend to a great extent on the typical activities of the enterprise.

The sales of investments sold by an insurance company would generally be classified as revenue, whereas the sales price less book value on the sale of an investment by a manufacturing enterprise would be classified as gain or loss.

Single step income statement

In reporting revenues, gains, expenses and losses, many accountants prefer a format called the single step income statement. In the single step income statement, just using revenue and expenses groups. Expenses are deducted from revenue to arrive at net income or loss. Income tax is reported separately as the last item before net income to indicate their relationship to income before tax. This format of income statement is widely used in financial reporting. The primary advantage of this format lies in the simplicity of presentation and the absence of any implication that one type of revenue or expense item has priority over another.

In some cases, it is impossible to present in a single income statement of all the desired expense detail. This problem is solved by including only the totals of expense groups in the statement of income and preparing supplementary schedules of expense to support the totals. Readers who wish to study all the reported data must give their attention to the supporting schedules.

Multiple step income statement

Another format which called a multiple step income statement. Accountants use this format to describe other important revenue and expense data to make the income statement become more informative and useful. This statement is recommended because it recognizes a separation of operating transactions from non operating transactions and matches costs and expenses with related revenues. In arriving at net income, three subtotals are presented when you are using a multiple step income statement.

1. Net sales revenue
2. Gross profit
3. Income from operations

The disclosure of net sales revenue is useful because regular revenues are reported as a separated item. Irregular or incidental revenue are disclosed elsewhere in the income statement. As a result, revenue from continuing operations should be easier to understand and analyze.

Reporting of gross profit for evaluating performance and assessing future earnings. It shows how successfully a company uses its resources as a result of competitive pressure.

Disclosing income from operations highlights the difference between regular and irregular or incidental activities. This disclosure helps users recognize that incidental or irregular activities are unlikely. Disclosure of operating earnings may assist in comparing with different companies and to know operating efficiencies.

When you are using a multiple step income statement, you will find several sections and subsections there

A.  Operating section

Reporting the revenue and expenses of the company’s principal operations.

#   Sales or revenue

#   Cost of goods sole

#   Selling expenses

#   Administrative or general expenses

They are subsequents of operating section

B.  Non operating section

Reports revenues and expenses resulting from secondary or auxiliary activities of the company. Special gains and losses that are unusual or infrequent, but not both are normally reported in this section

#   Other revenue and gains from nonoperating transactions

#   Other expenses and losses

They are subsequents of nonoperating section

C.  Income tax section

A short section of reporting tax on income from continuing operations.

D.  Discontinued operations section

Material gains or losses resulting from the disposition of a segment of the business.

E.  Extraordinary items section

Unusual and infrequent material gains and losses.

F.  Earning per share section

Last section of an income statement.

The breakdown above is commonly used for manufacturing concerns and for merchandising companies in the wholesale trade. Usually financial statement that are provided to external users have less detail than internal management reports. However, whether a single step or multiple step income statement is used, irregular transactions such as

#   Discontinued operations

#   Extraordinary items

#   Cumulative effect of changes in accounting principles

They should be reported separately following income from continuing operations.

How much detail to include in the income statement is always a problem. On the one hand, we want to present a simple income statement so that a reader can discover important facts. On the other hand we want to disclose the results of all activities and to provide more than just a skeleton report. As we will see that they can be presented in various formats as long as certain basic elements are always included.

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How to Convert a Cash Basis Transactions into Accrual Basis

An accountant often meets cash basis transactions which need to be converted to accrual basis for presentation to a banker or audit. The conversion of cash payments for expenses to the accrual basis can be seen as below 

 

#   Receipts in cash basis minus beginning accounts receivable plus ending accounts                                              receivable, to get net sales in accrual basis.

#   Receipts in cash basis plus ending accounts receivable minus beginning accounts receivable                            and ending unearned revenue, to get revenue in accrual basis.

#   Rent receipts in cash basis plus beginning unearned rent minus ending unearned rent and                                  beginning rent receivable, its results plus ending rent receivable to get rent revenue in                                  accrual basis.

#   Payment for goods in cash basis plus beginning inventory minus ending inventory and                                      beginning accounts payable, its results plus ending accounts payable to get cost of                               goods sold in accrual basis.

#   Payment for expenses in cash basis plus beginning prepaid expenses minus ending prepaid                              expenses and beginning accrued expenses, its results plus ending accrued expenses to get                         operating expenses in accrual basis.

#   Payments for property, plant and equipment in cash basis minus cash payments for property,                          plant and equipment plus periodic write off of the asset cost to get depreciation or                             amortization expenses.

How to convert cash receipts from customer to gross sales.

Cash receipts from customer plus cash discount and sales returns and accounts write off and ending accounts receivable. The results minus beginning accounts receivable to get gross sales.

Cash receipts from customers plus increase in accounts receivable or minus decrease in accounts receivable, to get net sales.

Cash payments for goods plus increase in accounts payable or decrease in accounts payable, to get net purchases.

Net purchases plus decrease in inventory or minus increase in inventory, to get cost of goods sold.

Wages paid during the year plus ending accrued wages minus beginning accrued wages, to get wages expense for the year.

Insurance premiums paid during the year minus ending prepaid insurance plus beginning prepaid insurance, to get insurance expense for the year.

Selling on capital stock or paying off long term debt are increases and decreases in cash, they are not revenue or expenses under either cash basis or the accrual basis. They are non-operating items.

To illustrate the use of this topic, assume Mr. Smith collected $160,000 during the year 2000 from his client and paid $60,000 for all operating expenses during the year 2000 in cash basis. According to a cash basis, net income during the year 2000 is $100,000 ($160,000 - $60,000).

On the beginning of the year 2000

                        Accounts receivable $24,000

                        Accrued expenses or liabilities $7,600

                        Prepaid expenses as assets $4,000

At the end of the year 2000

                        Accounts receivable $10,000

                        Unearned revenue $2,000

                        Accrued expenses or liabilities $13,600

                        Prepaid expenses as assets $6,000

To get Mr. Smith’s revenue in accrual basis $144,000 as follow

Collected in cash $160,000 plus ending accounts receivable $10,000 minus beginning accounts receivable $24,000 and ending unearned revenue $2,000

To get operating expenses in accrual basis $64,000 during the year 2000

Payment on all operating expenses $60,000 plus beginning prepaid expenses $4,000 minus ending prepaid expenses $6,000 and beginning accrued expenses $7,600 plus ending accrued expenses $13,600

To get net income in accrual basis $80,000 for the year 2000

Revenue in accrual basis $144,000 minus operating expenses in accrual basis $64,000

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