CHAPTER 13 The Complete Income Statement

SYNOPSIS

In this chapter, the author provides an in-depth discussion of (1) the different types of business
transactions and (2) the income statement. The discussion of transactions focuses on financing,
investing, and operating transactions, and how these transactions flow through to the balance
sheet and income statement.

The general income statement topics discussed are (1) the economic consequences associated
with income measurement and disclosure; (2) the different ways to measure income, including
comprehensive income, and how these address the objectives of financial reporting; and (3) the
disclosure rules that should be followed when preparing an income statement. The specific
issues discussed are operating revenues and expenses; nonoperating revenues and expenses;
intraperiod tax allocations; disposal of a business segment; extraordinary items; cumulative
effect of a change in accounting principles; and earnings-per-share disclosures.

The ethics vignette considers whether it is ethical for management to consider the impact of the
choice between debt and equity financing on its own compensation, where compensation is a
function of net earnings after interest expense.

The Internet research exercise examines the income statement of Yahoo to identify items that
could be considered non-operating.

The following key points are emphasized in Chapter 13:

1. Economic consequences associated with reporting net income.

2. Two different concepts of income: matching and fair market value.

3. A framework for financing, investing, and operating transactions.

4. Categories that constitute a complete income statement and how they provide measures of
income that address the objectives of financial reporting.

5. Intraperiod tax allocation.

6. Earnings per share disclosure on the income statement.

TEXT/LECTURE OUTLINE

The complete income statement.

I. Income statement.

A. Purpose—to measure the income generated during the accounting period.

B. Economic consequences of income measurement and disclosure.

1. Income serves as a measure of the company's performance during the

accounting period.
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2. Effect of income on stock and bond prices.

3. Role of income in debt covenants.

4. Role of income in management incentive compensation.

C. Different measures of income for different objectives.

1. The objectives of financial reporting are to provide information that is:

a) Useful for investment and credit decisions.

b) Helpful in assessing future cash flows.

c) Reflective of changes in a company's resources.

2. No single measure of income can achieve these broad objectives. Elements of

financial statements that are key to understanding the different measures are
found in the definitions of ten key concepts: assets, liabilities, equity,
investments by owners, distributions to owners, comprehensive income,
revenues, expenses, gains, and losses.

3. Comprehensive income represents a broad definition of income—any change

in the company's equity due to nonowner transactions.

a) This concept of income includes items not included in the computation of

net income, such as foreign currency translation adjustments and unrealized
gains and losses on available-for-sale securities (Chapter 8).

b) The FASB now requires that comprehensive income and its components
be reported and displayed with the same prominence as the other financial
statements.

4. The definitions distinguish revenues and expenses from gains and losses.
The nature of individual transactions must be considered to determine if and
how they should be reflected in income.

D. Two different concepts of income: matching and fair market value.

E. Financing, investing, and operating transactions: a framework.

1. Financing and investing transactions principally affect balance sheet accounts.

Financing and investing transactions are those transactions associated with
the following:

a) Exchanges with shareholders.

b) Exchanges of liabilities and shareholders' equity.

c) Issues and payments of debt.

d) Purchases, sales, and exchanges of assets.

e) Revenues and expenses.

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2. Classifying operating transactions:

a) Group A: normal and recurring operating revenues and expenses.

b) Group B: revenues and expenses from activities not germane to a

company's primary activity, or form activities that occur infrequently.

i) Extraordinary items.

ii) Disposals of segments

iii) Other revenues and expenses

A. Bank interest

B. Changes in asset and liability fair market values

c) Group C: Gains and losses due to mandatory changes in accounting

principles.

II. A complete income statement: disclosure and presentation

A. Operating revenues and expenses.

1) Asset and liability inflows and outflows associated with the acquisition and sale
of goods and services.

2) To be considered operating activities, the activities must be both usual (the

economic event is part of the company's normal operations; it is associated
with the company's central, ongoing activities) and frequent (the economic
event is expected to recur in the foreseeable future).

B. Other revenues and expenses.

1) Asset and liability inflows and outflows that are incidental to the company's
operating activities.

2) To be classified as other revenue or expenses (i.e., incidental activities), the

activities must be either unusual or infrequent, but not both. Both the
company and its environment must be considered in deciding whether an item
is unusual or infrequent.

C. Gains (losses) from disposing of a business segment.

1) A business segment is defined as a separate line of business, product line, or

class of service that represents an operation that is independent of the
company's other operations.

2) Components of gains (losses) from disposing of a segment.

a) Income (loss) from operating the business segment.

b) Gain (loss) on the disposal of the segment's net assets.

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c) Gains or losses from the disposal of a business segment are reported net of
any tax effect.

D. Extraordinary items.

1) Extraordinary items are material gains or losses that are both unusual and
infrequent. Consequently, such events are not classified as operating activities
or incidental activities.

2) Both the company and its environment must be considered in deciding

whether an item is both unusual and infrequent.

3) Extraordinary items are reported net of any tax effect.

E. Cumulative effect of changes in accounting principles.

1) Reasons for changing an accounting principle.

2) The cumulative effect of the change is reported net of any tax effect.

3) Voluntary versus mandatory changes.

III. Intraperiod tax allocation.

IV. Earnings-per-share (EPS) disclosures.

A. GAAP provides for EPS disclosures for income from continuing operations (after
taxes); disposals of business segments; extraordinary items; and the cumulative
effect of changes in accounting principles.

B. Both "basic" and "diluted" EPS are presented. Diluted EPS gives effect to dilution
that may result from additional shares that may be issued for such things as stock
options.

V. Income statement categories: useful for decisions but subjective

VI. International perspective; investments and income statement disclosure

VII. ROE exercise; using the right earnings number

VIII. ROE analysis

IX. Review problem

X. Ethics in the real world.

XI. Internet research exercise.

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LECTURE TIPS

1. Students often have trouble applying intraperiod tax allocation, especially with knowing
which items should be disclosed net of taxes and the direction of the tax effect (particularly
with losses). Care should be taken in explaining why intraperiod tax allocation is used and
which items are disclosed net of taxes. End-of-chapter exercises 13–13 and 13–14 and
problems 13–6, 13–8 and 13–9 are helpful in demonstrating the essentials of intraperiod
tax allocation.

2. The distinction should be stressed between operating revenues and expenses,

nonoperating revenues and expenses, income from continuing operations, disposal of a
business segment, extraordinary items, and the cumulative effect of a change in accounting
principle, because of the different relevancy of these income statement components for
assessing earning power. These differences are associated with earnings persistence.
Deciding whether an item is extraordinary requires a great deal of judgement and is difficult
even for seasoned professional accountants. Examples illustrating the difficulty of making
this decision should be provided. End-of-chapter exercises 13–5, 13–6, 13–9, 13–10, 13–
11, and 13–16; problems 13–2, 13–4, 13–5, 13–8, and 13–9; and the issues for discussion
1tems 13-1 through13-9 are especially useful.

OUTSIDE ASSIGNMENT OPPORTUNITIES

Group study of income statement components both across time and within and across
industries (continuing assignment for Chapters 6–14)

1. Using the most recent annual report of a major public company in one of the four general
industry groupings, identify or compute the items listed below for the two most recent years.
Compare the items across time. Relate your findings to the economic characteristics and
current conditions in the industry and the company’s strategy for competing. Prepare a
written summary of your findings. Report findings in a class discussion session in which
comparisons will be made both across time and within and across industries.
 Common-size income statement (see Chapter 5)
 Significant accounting policies affecting recognition of revenue and expenses
 Description and nature of special items: nonoperating revenues and expenses,
discontinued operations, extraordinary items, and the cumulative effect of a
change in accounting principles
 Presentation of comprehensive income
 Earnings per share disclosures

Analyzing the quality of earnings

2. Obtain the annual report for a company with several nonrecurring items (such as Bristol-
Meyers Squibb for 2008 - Figure 13-6). Obtain and read the Comiskey-Mulford-Choi article
on analyzing the persistence of earnings referenced below.1 Use the method discussed in
the article to evaluate the company's earnings for the given three years in the annual report
in terms of persistence and cash flow. Summarize your conclusions in writing, supported
with computations.

ANSWERS TO IN-TEXT DISCUSSION QUESTIONS

1
Eugene E. Comiskey, Charles W. Mulford, and Hyun-Dol Choi, “Analyzing the Persistence of Earnings: A
Lender’s Guide,” Commercial Lending Review, Winter 1994/1995, pp. 4–23.
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553. The settlement for BP would be included as a part of income, but not as a part of core
activities. Analysts following the oil industry would not consider this a part of BP’s
recurring business and so would not consider this an ongoing part of the business when
considering BP’s core operating income. Most legal settlements are one-time events.
This situation is somewhat unique; however, because of the size of incident. It is likely
that other settlements and expenses related to the incident persist. A trust was
established by BP to cover these ongoing legal issues. Treatment under GAAP and
IFRS for this issue is substantially similar.

556. The Gap did not recognize a loss on the reissuance of treasury stock. Such transactions
with shareholders are purely financing transactions which never result in reported
income or loss on the income statement.

556. The effect on the basic accounting equation for Honeywell was as follows:
ASSETS = LIABILITIES +
Long-term debt issued +$102 million +$102 million
Debt redeemed -$529 million -$529 million

The above answer neglects the portion of the debt payments being treated as interest
because the interest amount was not provided. Interest payments would increase
expenses, reducing retained earnings and shareholders’ equity.

557. Southwest’s investment of $1.3 billion in property and equipment would be an investing
activity. The cost would be capitalized as an asset and depreciated over its expected
useful life. The effect on current and future income statements would be the annual
depreciation charges. Any remaining book value at the time of disposal would enter into
the computation of a gain or loss on disposal, which also would be reflected in the
income statement.

558. Cost of revenues belongs under Group A. Asset impairments belong to Group B under
other revenues and expenses (changes in asset fair market values). Gains and losses
on operating assets belong to Group B under other revenues and expenses (gains and
losses recognized on sales of long-lived assets). Restructuring costs belong under
Group B under extraordinary items.

560. A gain on the sale of investments would most likely be considered a usual and frequent
transaction at Bank of America, rather than JCPenney. An important component of a
bank’s business model is engaging in investment transactions. On the other hand,
investment transactions at J.C. Penney would be peripheral to its main business of retail
sales.

561. The gain would appear under the caption “other revenues and expenses” because the
sale of the investment was a secondary or auxiliary activity to the normal operations of
Limited Brands.

562. Extraordinary items are those that are both unusual or infrequent. Weather hazards for a
food grower are not infrequent, as evidenced by the fact that Dole incurred two sizeable
weather-related losses within one year. Such losses are distinct enough from normal
operations that they would be disclosed separately, but not as extraordinary items.

664. The income trend across time before considering the accounting changes was
downward. The income trend across time after considering the accounting changes was
also downward. The downward trend is the only one evident anywhere in this
presentation. Avis will not be able to continue to improve its net income annually by
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changing accounting methods. Accounting method changes generate no cash and

should usually be factored out in making comparisons of income across time.

565. The $1.2 billion change was apparently offset by $.2 billion in tax savings, making the
net charge to income only $1 billion.

566. Shares can be estimated by dividing net income by the earnings per share (EPS) as
follows:
2012 2011 2010
Net income (millions) $1,960 $3,709 $3,102
EPS-basic $1.17 $2.18 $1.80
EPS-diluted $1.16 $2.17 $1.79
Shares (millions) =
Net income/EPS
Basic 1,675 1,701 1,723
Diluted 1,690 1,709 1,732

Shares for basic EPS represent common shares actually outstanding. Shares for diluted
EPS take into account the increase in the number of shares if all potentially dilutive
securities were converted to common shares.

567. The following items would be candidates for "other gains and losses":

 Impairment charge for BMS-986094 intangible asset

 Other (income)/expense

Net income from operations would be net earnings (as presented in Figure 13-6),
adjusted to (1) add back the Impairment charge and (2) subtract out the Other income
items for these three years.

567. ‘Real and repetitive’ earnings would be earnings related to core ongoing activities. Real
and repetitive items are expected to continue into the future therefore providing some
predictive value which is essential to successful third party use of financial statements.
The income statement is organized in a way that is meant to isolate ‘one time items’ that
may sway earnings in a given period and give the user the possibility of identifying
earnings that will continue going forward.

CHARACTERISTICS OF END-OF-CHAPTER ASSIGNMENTS

Difficulty Description
Brief exercises:
BE13–1 E Nonrecurring items
BE13–2 E Effects on the basic accounting equation
BE13–3 M Interpreting non-operating items
BE13–4 M Understanding comprehensive income
Exercises:
E13–1 E Which statement is affected?
E13–2 E Classifying transactions
E13–3 M Comprehensive income
E13–4 M Debt covenants expressed in terms of income
E13–5 M Special items
E13–6 M Disposal of a business segment
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Difficulty Description

E13–7 M Management choices and earnings persistence

E13–8 M Management choices and earnings persistence
E13–9 H Interpreting non-operating items-IFRS
E13–10 M Accounting for unusual losses
E13–11 M Economic consequences of an extraordinary item
E13–12 M Earnings-per-share disclosure
E13–13 M Intraperiod tax allocation and the financial statements
E13–14 M Intraperiod tax allocation
E13–15 H Covenant restrictions and income reporting
E13–16 H Stock market reactions to income reporting
E13–17 H Different ways to measure income

Problems:
P13–1 E Classifying transactions
P13–2 M Bonus contracts’ effect on management's decisions
P13–3 M Financing, investing, and operating transactions
P13–4 M Preparing an income statement
P13–5 E Disclosing extraordinary items
P13–6 M Intraperiod tax allocation, income tax expense, and
income tax liability
P13–7 M Earnings per share and discontinued operations
P13–8 M EPS disclosure
P13–9 M Disclosing net of tax, and the EPS calculation
P13–10 H Preparing an income statement
P13–11 M Special items and earnings trends
P13–12 M Recognized income and expense under IFRS
P13–13 H Comprehensive problem
Issues for discussion:
ID13–1 M Comprehensive income
ID13–2 M Rating agencies and assessing risks
ID13–3 E Extraordinary losses
ID13–4 M Disclosing non-operating items
ID13–5 M Income statement classification
ID13–6 M Litigation, reported income, and stock prices
ID13–7 M Income statement categories
ID13–8 M Analyzing special income statement items
ID13–9 M Recurring vs. nonrecurring items
ID13–10 M Classification differences-IFRS vs. GAAP
ID13–11 M The annual report of Google