Question

Discuss the importance of income from continuing operations and describe its components.

The purpose of the income statement is to summarize the profit-generating activities that occurred during a particular reporting period. The purpose of the statement of cash flows is to provide information about the cash receipts and cash disbursements of an enterprise that occurred during the period.

TConsider important issues dealing with income statement content, presentation, and disclosure and to provide an overview of the statement of cash flows.

Answer 1

Continuing Operations
What are 'Continuing Operations'
Continuing operations is the net income category found in the income statement that accounts for a company’s regular, daily business activities, referring to the tasks required to make a product or service and deliver it to a customer. To succeed over the long term, a business must consistently generate earnings from operations, and a multi-step income statement reports income from continuing operations separately from non-operating income.

Because analysts are interested in income from continuing operations, many experts in the financial markets separate earnings due to mergers, acquisitions, business divestitures and discontinued operations.

BREAKING DOWN 'Continuing Operations'
.A successful business should use continuing operations as the primary income source; that is, a company should make the bulk of its earnings from carrying out the reason it exists. For example: Coca-Cola should make most of its earnings from producing and selling beverages; U.S. Steel from producing and selling steel and iron; Bank of America from issuing loans and other banking services. If a company is found to be making most of its money from non-core activities, analysts may raise red flags - for instance, if a car company is making far more money from its financing and credit operations than from selling automobiles.

Profit margin is a financial ratio defined as net income divided by sales, and the hypothetical clothing company XYZ should be driving the majority of both net income and sales from continuing operations. XYZ can grow sales by adding new customers and creating new clothing product lines, and the firm can cut costs and increase prices to generate more income for every dollar of sales. Income earned from the equipment sale is included in profit margin, but selling assets is not a sustainable profit generator.

Well-managed companies also maximize the sales generated from using assets, and the asset turnover ratio is defined as total sales divided by average total assets. When XYZ purchases machinery and equipment to make clothing, the firm wants to maximize the sales generated from using the assets to make and sell clothing. If XYZ recognizes a gain on a sale of investment securities, for example, the transaction generates more income, but it does not improve the asset turnover ratio.

How a Multi-Step Income Statement Works
A multi-step income statement provides more detail on a company's income sources and expenses, which gives the financial statements reader more detail to make informed business decisions. Assume, for example, that XYZ manufactures casual clothing and that it also sells an expensive piece of machinery during the year.

The multi-step format starts with sales minus the cost of sales to calculate gross profit, and XYZ's cost of sales includes both material and labor costs to manufacture clothing. Operating expenses such as wages, supplies and lease expenses are subtracted from gross profit to arrive at operating income. Other revenue and expenses are posted after operating income, along with income taxes, and the remaining balance is company net income. The gain or loss on a machinery sale is posted to other revenue and expenses, which is an unusual item that is not directly related to daily business operations.

The Components of Net Income:

Operating income from continuing operations - This comprises all revenues net of returns, allowances and discounts, less the cost and expenses related to the generation of these revenues. The costs deducted from revenues are typically the COGS and SG&A expenses.

Recurring income before interest and taxes from continuing operations - In addition to operating income from continuing operations, this component includes all other income, such as investment income from unconsolidated subsidiaries and/or other investments and gains (or losses) from the sale of assets. To be included in this category, these items must be recurring in nature. This component is generally considered to be the best predictor of future earnings. However, non-cash expenses such as depreciation and amortization are not assumed to be good indicators of future capital expenditures. Since this component does not take into account the capital structure of the company (use of debt), it is also used to value similar companies.

Recurring (pre-tax) income from continuing operations - This component takes the company's financial structure into consideration as it deducts interest expenses.

Pre-tax earnings from continuing operations - Included in this category are items that are either unusual or infrequent in nature but cannot be both. Examples are an employee-separation cost, plant shutdown, impairments, write-offs, write-downs, integration expenses, etc.

Net income from continuing operations - This component takes into account the impact of taxes from continuing operations.

Statement of Cash Flows
Investors and potential investors can gain a lot of useful information from the statement of cash flows, which shows, in detail, how a company's cash position has changed from one period to another. The cash flow statement, as prepared under U.S. generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS), omits some very useful information for investors. Thus, this information needs to be included in the disclosures at the bottom of the cash flow statement.

Disclosure required are :-

A reconciliation of the ending cash balance to the statement of financial position headings. (e.g. cash, bank overdraft, bank deposits)
Cash flows relating to the acquisition and disposal of business entities
Changes in assets and liabilities which are related to non-cash financing or investing activities. (e.g. assets acquired under finance leases)
Cash which is not available for use. The amount and nature of any cash held by the entity, which is not available for use should be disclosed. The reason for any restriction should also be disclosed.