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SC&C Ch.6: Financial Statements I: The Income Statement

Introduction
Various groups are affected by, and have a stake in, the financial reporting
requirements of the FASB and the SEC
Introduction
Investors in equity securities are the central focus
of the financial reporting environment
Introduction
• Investing involves
• Giving up current resources

 For future uncertain resources.

 Therefore, investors require information assessing

future cash flows.
The Economic Consequences of Financial
Reporting
• Financial reporting has economic consequences including:
1. Financial information can affect the distribution of wealth among investors.
 More informed investors, or investors employing security analysts, may be able to
increase their wealth at the expense of less informed investors.
 The Economic Consequences of
Financial Reporting
2 . Financial information can affect the level of risk accepted by a firm.
 Focusing on short-term, less risky, projects may have long-term
detrimental effects.

3. Financial information
 Can affect the rate of capital formation in the
economy
 And result in a reallocation of wealth between
consumption and investment within the economy.
The Economic Consequences of
Financial Reporting

4 . Financial information can affect how investment is allocated among

firms.

 These economic consequences may have a differential impact on

different user groups and future deliberations of standards must
consider these economic consequences
Income Statement Elements
• SFAC No. 8 indicates that the primary
focus of financial reporting is to
provide information about a
company’s performance
Income Statement Elements
 Vehicle for relaying performance assessments to
investors
 SFAC No. 6: defined the elements of the income
statement
 Revenues
 Gains
 Expenses
 Losses
Each Term Is Defined As Changes in Assets
and Liabilities
• Differences between changes in assets approach and inflow and
outflow definition are:

1. Determining Earnings

Change in net economic VS Views as a measure of

resources effectiveness

2. Defining Earnings

Definition of Assets and VS Definition of Revenue &

Liabilities Expenses

3. Creating deferred charges

Recognized only when VS Created as a result of
they are economic measuring income
resources or obligations
Each Term Is Defined As Changes in Assets
and Liabilities

4. Both agree on importance of income statement

5. Population from which the elements of financial statements can
be selected

Net economic resources and

to the transactions and Items necessary to
events that change VS match revenues and
measurable attributes of costs
those net resources
Statement Format
• The preparation of the income statement has been
impacted by differences of opinion on the definition
of ongoing operations.
• Two views:

1. All inclusive
2. Current operating performance
Current Income Statement Format
• Proscribed in APB Opinion No. 9 as:
Revenues
Less: Cost of goods sold
= Gross profit
Less: Administrative and selling expenses
Plus: Other gains
Less: Other losses
Excludes prior-
= Income from continuing operations period adjustments
Discontinued operations
Extraordinary items
Change in accounting principle

= Net income
Income From Continuing Operations

• Normal and recurring revenues and expenses

• Sustainable income
• Income tax (recurring items)
• Nonrecurring items (Each net of their tax effect)
• Discontinued operations
• Extraordinary items
• Change in accounting principle
Tootsie Roll and Hershey

• Tootsie Roll Industries and The Hershey Company

are internationally known candy manufacturers.

 We will use information from the two companies’ fiscal 2010

- 2014 annual reports to illustrate the disclosure of
information in this and subsequent chapters.
Discontinued Operations
• Why special treatment?
• Arise from a disposal of a component of a business
• Comprising operations and cash flows that can be
clearly distinguished, operationally and for financial
reporting purposes, from the rest of the entity.
 Original criteria contained in APB Opinion No. 30.
 This release required the separate presentation of (1) the results
of operations of the disposed segment, and (2) gain or loss on
the sale of assets for disposed segments including any operating
gains or losses during the disposal period.
 Time of disclosure was determined by whether a gain or loss
was expected on the measurement date
 Amended by SFAS 144
SFAS No. 144 FASB ASC 360

• Changed reporting of discontinued operations:

• Unit must qualify as a component (distinguishable
assets and cash flows
• If so:
• Operations and cash flows of component must be eliminated
as a result of the transaction
• Company does not retain any significant involvement in
operations of component after disposal
• Neither Hershey or Tootsie Roll disclosed any
discontinued operations
Accounting for Discontinued Operations
Under Continuing Review
• FASB Exposure Draft
• September 2008
• Amending the Criteria for Reporting a Discontinued
Operation
• IASB Exposure Draft
• Discontinued Operations
• Definitions in SFAS No. 144 and IFRS No. 5 not
convergent
• Proposed definition:
• An operating segment that has been disclosed of or is up for
sale; or
• A business that meets the criteria to be classified as held for
sale on acquisition.
Discontinued Operations FAS 2013-46
• Later in 2012 the FASB met to redeliberate the issue and later issued ASU
2014-08 which changed the criteria for determining disposals to be
presented as discontinued operations.
• Why issued?
• The new definition of a discontinued operation is a component or group of
components that has been disposed of or is classified as held for sale,
together as a group in a single transaction, and represents a strategic shift
that has (or will have) a major effect on an entity's financial results as
determined by:
i. Meets the criteria to be classified as held for sale;
ii. Is disposed of by sale; or
iii. Is disposed of other than by sale
• Decisions:
• Has a strategic shift occurred?
• Will it have an impact
• Possible metrics
• Higher threshold for recognition results in additional disclosures
Extraordinary Items
• Prior to 2016, a special category of nonrecurring items
termed extraordinary items was reported on corporate financial
statements.
• Original definition APB No. 9 – not expected to recur
• Problems – similar items not being classified similarly
• APB Opinion No. 30
• Unusual nature
• Infrequency of occurrence
• Problem:
• Requirements do not always separate recurring and non-recurring
items – unusual but not infrequent
• As a result, there is a tendency to increase the variability of
operating income and decrease the predictive ability of earnings
• The events of 9/11
Extraordinary Items

• The presentation of extraordinary items recently came

under additional review and on January 9, 2015, the
FASB issued Accounting Standards Update (ASU)
2015‐01, Income Statement—Extraordinary and
Unusual Items, as a part of the simplification initiative
(discussed later)
• This ASU eliminates the concept of extraordinary items
from U.S. GAAP.
• It was issued after the FASB heard from stakeholders
that the concept of extraordinary items causes
uncertainty because it is unclear when an item should
be considered both unusual and infrequent
Accounting Changes
• The accounting standard of consistency requires that
similar transactions should be reported similarly each year
• Occasionally an entity may find that reporting needs are
better served by changing a method of accounting
• If so, the comparability of financial statements is impaired
• Basic question: Should previously issued financial
statements be amended?
Accounting Changes

• APB Opinion No. 20 originally identified

four types of accounting changes:
1. Change in an accounting principle
Occurs when an entity adopts a GAAP that differs from one previously
used for reporting purposes.
2. Change in an accounting estimate
Result from the necessary consequences of periodic presentation.
3. Change in a reporting entity
Caused by changes in reporting units, which may be the result
a. Consolidations,
b. Changes in specific subsidiaries, or a
c. Change in the number of companies consolidated.
4. Errors
Not viewed as accounting changes.
Result of mistakes or oversights such as the use of incorrect accounting
methods or mathematical miscalculations.
Types of Accounting Changes
• Change in accounting principle
• How reported
• APB Opinion No 20 – Catch-up adjustment with 3 exceptions
• SFAS No 154 – Retrospective application

 Change in accounting estimate

 How reported – Prospective application
 Change in accounting entity
 How reported- Retrospective application
 Errors
 How reported –Prior period adjustments
 Earnings Per Share
Net income - Preferred dividends
Average # of common shares outstanding

• Basic calculation

 APB No. 9 – concept of residual and senior securities

 APB No. 15
 Simple vs. complex capital structure
 Required calculation of primary and fully diluted earnings per share
 The concept of common stock equivalents

 Criticism of APB No. 15 - arbitrary, complex and illogical

 The FASB and IASC project
SFAS No. 128
• Reasons for the change
1. Basic EPS and diluted EPS data would give users the most factually range
of possibilities
2. Use of a common international method is important due to the data based
oriented financial analysis and internationalization of business
3. The notion of common stock equivalents does not operate efficiently in
practice
4. The computation of primary EPS is complex and not well understood or
consistently applied
5. Presenting basic EPS eliminates criticism about the arbitrary nature of the
determination of common stock equivalents
 SFAS No. 128

• Requires presentation of EPS by all publicly traded

companies issuing common stock
• Companies with a simple capital structure will only
report basic earnings per share. All others will report
basic and diluted
• Calculation of basic EPS

Net income - Preferred dividends

Average # of common shares outstanding
Diluted Earnings Per Share
• Objective
• Historical - basic
• Pro forma - diluted
• Calculation:
• Includes all potential dilutive securities
1. Options and warrants - treasury stock method
2. Written put options – reverse treasury stock method
3. Convertible securities
• “as-if-converted”
4. Contingently issuable securities
 Usefulness of EPS
• Objectives of EPS reporting are to provide investors an indication
of:
1. Value of the firm
2. Expected future dividends
• Question: Historical or forecasted?
• Summary indicator
• Hershey has a complex capital structure and discloses basic as well
as diluted earnings per share on its income statements
• Tootsie Roll has a simple capital structures and discloses only one
earnings per share figure
SFAS No 130 - Reporting Comprehensive
Income
• Reasons for the initial project
1. Off-balance sheet financing
2. The practice of reporting some
items of comprehensive income
in stockholders’ equity
3. Acknowledged need for
harmonization of accounting
standards
Definitions

• Comprehensive income
• The change in equity (net assets) of a business enterprise
during a period from transactions and other events and
circumstances from nonowner sources.

• Other comprehensive income

• Revenues, expenses, gains, and losses included in
comprehensive income but excluded from net income.
SFAS No 130 - Reporting Comprehensive
Income
• Original issues:
1. Should comprehensive income be reported?
2. Should cumulative accounting adjustments be included in
comprehensive income?
3. How should the components of comprehensive income be classified for
disclosure?
4. How should comprehensive income be disclosed
in the financial statements?
5. Should the components of other comprehensive
income be disclosed before or after their related
tax effects?
Should Comprehensive Income Be
Reported?
• SFAS No 130
• Requires the disclosure of comprehensive income and
• Discusses how to report and disclose comprehensive income and
its components, including net income.
• Does not specify when to recognize or how to measure components
 Should Cumulative Accounting
Adjustments Be Included?
Include As Part Of
Cumulative Accounting Comprehensive Income
Adjustments

Cumulative
Accounting
Adjustments
How Should the Components of
Comprehensive Income Be Classified
for Disclosure?
• Requirement:
• Companies must disclose an
amount for net income

• That amount must be accorded equal prominence with the

amount disclosed for comprehensive income
• Items of other comprehensive income are classified based
on their nature
How Should Comprehensive Income be
Disclosed in the Financial Statements?

• Requires a gross disclosure technique for

items of other comprehensive income
• ASU 2011-05 allows for the disclosure of
comprehensive income
• On income statement
• On a separate statement
• Previous alternative treatment of disclosure in statement of
stockholders’ equity no longer allowed
Should Components of Other Comprehensive
Income Be Displayed Before or After Their Related
Tax Effects.
• Allows the components of other comprehensive income
to be disclosed either
• Net of related tax effects or
• Before related tax effects with one amount shown for the aggregate
income tax expense or benefit related to the total amount of other
comprehensive income

• Other comprehensive income is transferred to a separate

component of stockholders’ equity

• Hershey’s discloses changes in other comprehensive

income in its consolidated statement of shareholders’
equity as a single net amount. (No longer allowed)

• Tootsie Roll includes the calculation of other

comprehensive income on its income statement.
Prior Period Adjustments
• An adjustment to beginning retained earnings
balance
• Original criteria in APB No. 9
• Examples were income tax disputes
and litigation
• SEC Staff Bulletin No. 8
and APB Opinion No. 16
• Correction of an error
• Adjustments from realization of operating loss
carryforward of purchased subsidiary
The Simplification Initiative

• In June, 2014, the FASB announced a plan to reduce

the complexity of accounting standards

• Termed the simplification initiative, involves adding

narrow-scope projects to the FASB’s agenda
• Identified by various stakeholders as
opportunities
to simplify GAAP
• In a relatively short time period.
Proposed Format of the
Statement of Comprehensive Income
• Under Phase B of the financial statement presentation
project the FASB and the IASB are planning to release a
plan to recast financial statements into a new format.
• One possible result is the elimination of the current definition of
net income.

• In its place, financial statement users may find a number of profit

figures that correspond to different corporate activities.

• The rationale for the new presentation is that focusing on the net
profit number has been seen as one cause for the fraud and
stock-market excesses that characterize the past several years.
 Proposed Format of the
Statement of Comprehensive Income

• The new proposed income statement has separate

categories for the disclosure of a company’s operating
business, its financing activities, investing activities, and
tax payments.
• Each category also contains an income subtotal.
• The proposal adopts a single statement of comprehensive income
format that combines income statement elements and
components of other comprehensive income into a single
statement.
• Items of other comprehensive income are to be presented in a
separate section following the income statement elements
 Proposed Format of
Statement of Comprehensive Income
▪ Separate categories for disclosure of
▪ Operating business activities
▪ Financing activities
▪ Investing activities
▪ Tax payments
▪ Subtotal for each category
▪ All income and expense items to be classified into
operating, investing, and financing
▪ Disaggregate line items by function
▪ Function: the primary activities in which an entity is engaged
▪ Further disaggregate line items by nature
▪ Nature: the economic characteristics or attributes that distinguish assets,
liabilities, and income and expense items that do not respond equally to
similar economic events
The Value of
Corporate Earnings

• The financial analysis of a company’s income

statement focuses on a company’s operating
performance by focusing on such questions as:

1. What are the company’s major sources of revenue?

2. What is the persistence of a company’s revenues?
3. What is the company’s gross profit ratio?
4. What is the company’s operating profit margin?
5. What is the relationship between earnings and the
market price of the company’s stock?
Sources of Revenue

• The financial analysis of a diversified company requires a

review of the impact of various business segments on the
company as a whole.
• Hershey reports segmental information for two segments:
• Domestic
• International
• Tootsie Roll reports segmental information for two segments:
• Domestic
• International
• Neither company discloses any information about
major customers.
Persistence of Revenues

5 Year Revenue Trend Analysis

140.0%
120.0%
100.0%
80.0%
60.0%
40.0%
20.0%
0.0%
2010 2011 2012 2013 2014
Hershey Tootsie Roll
Management’s Discussion
and Analysis
• The MD&A section of a company’s annual report can provide
valuable information on the persistence of a company’s earnings
and its related costs.

• SEC requires companies to disclose any changes or potential

changes in revenues and expenses to assist in the evaluation of
period-to-period deviations.

• Both Hershey and Tootsie Roll indicated increasing trend in gross

profit percentage from 2010 to 2014
Gross Profit Analysis
Gross Profit Percentage = Gross Profit ÷ Net Sales

5 Year Gross Profit Trend Analysis

50.0%

40.0%

30.0%

20.0%

10.0%

0.0%
2010 2011 2012 2013 2014
Hershey Tootsie Roll
Net Profit Analysis

Net Profit Percentage = Net Income ÷ Net Sales

5 Year Net Profit Trend Analysis
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
2011 2010 2012 2013 2014
Hershey Tootsie Roll
Operating Profit Percentage

Operating Profit Percentage = Operating Profit ÷ Net Sales

5 Year Operating Profit Trend Analysis

20.0%

15.0%

10.0%

5.0%

0.0%
2010 2011 2012 2013 2014
Hershey Tootsie Roll
The Value of Corporate Earnings

• Relationship between corporate earnings and stock prices

Measured by price earnings ratio

Hershey = 26.6
Tootsie Roll = 29.2

P/E Ratio = Current market price per share ÷ EPS

Price-Earnings Ratios
Operating Profit Percentage = Operating Profit ÷ Net Sales

5 Year Price-Earnings Trend Analysis

35.0
30.0
25.0
20.0
15.0
10.0
5.0
-
2010 2011 2012 2013 2014
Hershey Tootsie Roll
International Accounting Standards
• In addition to release of IAS No. 33 on EPS, IASB has:
1. Defined the concepts of performance and income in “Framework for the
Preparation and Presentation of Financial Statements”

2. Discussed the content and format of the income statement in IAS No. 1, “
Presentation of financial Statements”

3. Discussed some components of the income statement in an amended IAS

No. 8, now titled "Accounting Policies, Changes in Accounting Estimates
and Errors"

4. Amended IAS No. 33

5. Discussed the required presentation and disclosure of a discontinued

operation in IFRS No. 5, “Non-Current Assets Held for Sale and
Discontinued Operations”

6. Issued an amendment to IAS No. 1

IASB Framework Definitions: Performance &
Income
• Profit is used
 To measure performance; or
 As the basis for other measures
 The IASB definition of income
encompasses both revenue and
expenses
• Measurement of income is dependent on the
concept of capital maintenance employed
Physical capital maintenance
Financial capital maintenance
 IAS No. 1
• Objective is to prescribe the basis for presentation of general‐purpose
financial statements, to ensure comparability both with the entity’s financial
statements of previous periods and with the financial statements of other
entities.
• Requires an income statement and a statement of comprehensive
income (separate or combined)
• Must include:
• Revenue
• Finance costs
• Share of the profit or loss of associates and joint ventures accounted for
using the equity method
• Tax expense
• Discontinued operations including ,
• Gain or loss on operations
• Gain or loss on disposal of asset
• Profit or loss, each component of OCI classified by nature,
• Share of the OCI of associates and joint ventures accounted for using the
equity method
• Total comprehensive income
IAS No. 8: Accounting Policies, Changes in
Accounting Estimates and Errors
• Goal of IAS No. 8 is to prescribe the classification, disclosure, and
accounting treatment of certain items in the income statement so that
all entities prepare and present their income statements in a consistent
manner
• When a standard or an interpretation specifically applies to a
transaction, it must be followed
• In the absence of a standard or an interpretation that specifically
applies to a transaction, judgment should be used
IAS No. 8: Accounting Policies, Changes in
Accounting Estimates and Errors
In using judgment, the following hierarchy of sources is to be
applied in descending order of authoritativeness:

International Financial Reporting Standard, including any appendices

that form part of the Standard

Interpretations

Appendices to an IFRS that do not form part of the

Standard

Implementation guidance issued by IASB in

respect of the Standard
IAS No. 8: Accounting Policies, Changes
in Accounting Estimates and Errors
• Companies are required to select and apply accounting
policies on a consistent basis for similar transactions.
• A company may change an adopted accounting policy only
if the change either
1. Is required by a standard or interpretation, or
2. Results in the financial statements providing reliable
and more relevant information about the effects of
transactions, other events, or conditions on the entity’s
financial position, financial performance, or cash flows
• If a change in accounting policy is required by a new IASB
pronouncement, the change should be accounted for by the
requirements of the new pronouncement. However, if the
new pronouncement does not include specific transition
provisions, then the change in accounting policy is applied
retroactively.
IAS No. 8: Accounting Policies, Changes in
Accounting Estimates and Errors
• Errors
• Now defined as newly discovered omissions or
misstatements of prior period financial
statements based on information that was
available when the prior financial statements
were prepared
• All material errors will be accounted for
retrospectively
• By restating all prior periods presented
• And adjusting the opening balance of retained
earnings of the earliest prior period presented
• Cumulative effect recognition in income is
prohibited
IAS No. 33: Earnings per share
• Objective is to prescribe principles for determining and presenting
EPS amounts to improve performance comparisons between
different entities in the same reporting period and between different
reporting periods for the same entity.
• It applies to entities whose securities are publicly traded or that are
in the process of issuing securities to the public.
• IAS No 33 is fully convergent with SFAS No 15 discussed earlier
IFRS No. 5: Non-Current Assets Held for
Sale and Discontinued Operations
• SFRS No. 5 replaces IAS No. 35.
• Outlines the accounting treatment for noncurrent assets held for sale (or for distribution
to owners).
• Assets held for sale are not depreciated,
o Measured at the lower of carrying amount and fair value less costs to sell,
o Presented separately in the balance sheet.
 IFRS No. 5: Non-Current Assets Held for
Sale and Discontinued Operations
• Discontinued operations

Post-tax profit Post-tax gain or Cost to sell or fair

or loss of the
discontinued
operation
+
loss recognized
on the
measurement to
fair value
- value
adjustments on
the disposal of
the assets (or
disposal group)

Should be presented as a single amount on the face of the

income statement
IFRS No. 5: Non-Current Assets Held for
Sale and Discontinued Operations
• Detailed disclosure of revenue, expenses, pre-tax profit or loss, and
related income taxes is required
• Either in the notes or on the face
of the income statement in a
section distinct from continuing
operations.
• Such detailed disclosures must
cover both the current and all
prior periods presented in the
financial statements.

• IFRS No 5 prohibits the retroactive

classification as a discontinued operation, when the discontinued
criteria are met after the balance sheet date.
Amended IAS No.1

▪Allows either a one or two statement approach to

the presentation of Other Comprehensive Income
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