Question

a) the information in the statement of comprehensive income if used with information in the other financial statements help external users answer several questions. State and briefly explain the qusetions that can be answered by analysing the statement of comprehensive income.

b) Analysis of earnings quality is often affected by an analyis of receivables and their collectability. The analyst must be alert to changes in the allowance computed relative to sales, receivables or indusry and market conditions. Two key questions arise for the analyst:

i) collection risk

ii) authenticity of receivables

Explain the key issues or questions an analyst should consider when analysing:

i) collection risk

ii) authenticity of receivables

c) Explain any six methods/ ways a firm can undertake earnings management

Answer 1

Question a:

A statement of comprehensive income contains of two main things : Net Income and Other Comprehensive Income (OCI). Net income is obtained by preparing an income statement whereas OCI consists of all the other items that are excluded form the income statement.

Income statement is used to provide a summary of all the sources of revenue and expenses, including payable taxes and interest charges. Ideally, the aim of preparing an income statement is to find a company’s net income.

Unfortunately, net income only accounts for the earned income and incurred expenses. There are times when companies make gains or losses resulting from the fluctuations in the value of their assets. The outcome of such events is recognized in the cash flow statement but not in the income statement, which is where other comprehensive income comes in. Any transactions not captured in the income statement are accounted for in the OCI report. It entails items such as:

• Gains or losses from pension and other retirement programs
• Adjustments made to foreign currency transactions
• Gains or losses from derivative instruments
• Unrealized gains or losses from debt securities
• Unrealized gains or losses from available-for-sale securities

OCI is mainly used to value bigger corporations that encounter such financial events.

The statement of comprehensive income is computed by adding the net income – which is found by summing up the recognized revenues minus the recognized expenses – to other comprehensive income, which captures any other items excluded from the income statement.

The statement of Comprehensive income encompasses the income statement and other comprehensive income. It sheds light on a Company's financial events.

Some of the uses of an income statement are as under :

1. Detailed revenue information : The primary purpose of an income statement is to provide information on how a company is raising its revenue and the costs incurred in doing so. The income statement is very thorough in highlighting these details. Not only does it explain the cost of goods sold, which relate to the operating activities, but it also includes other unrelated costs such as taxes. Similarly, the income statement captures other sources of revenue which are not associated with the main operations of a company. This entails items such as the accrued interest from business investments.

2. Analysis tool for investors : The SCI, as well as the income statement, are financial reports that investors are interested in evaluating before they decide to invest in a company. The statements show the earnings per share or the net profit and how it’s distributed across the outstanding shares. The higher the earnings for each share, the more profitable it is to invest in that business.

Question b

Collection Risk - Most provisions for uncollectible accounts are based on past experience, full information to assess collection risk for receivables is not usually included in financial statements.

An Analyst should consider the following issues when analyzing Collection Risk:

• Comparing competitors’ receivables as a percentage of sales with those of the company under analysis
• Examining customer concentration—risk increases when receivables are concentrated in one or a few customers
• Computing and investigating trends in the average collection period of receivables compared with customary credit terms for the industry
• Determining the portion of receivables that are renewals of prior accounts or notes receivables

Authenticity of Receivables

Following issues should be considered while analyzing authenticity of receivables:

• The description of receivables in financial statements or notes is usually insufficient to provide reliable clues as to whether receivables are genuine, due, and enforceable.
• One factor affecting authenticity is the right of merchandise return. Liberal return privileges can impair quality of receivables.
• Receivables also are subject to various contingencies. Analysis can reveal whether contingencies impair the value of receivables.