ACCOUNTING THEORY:

TEXT AND READINGS

RICHARD G. SCHROEDER
MYRTLE CLARK
JACK CATHEY
CHAPTER 6

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
 Elements of the Income Statement

 SFAC No. 1 indicates that the primary

focus of financial reporting is to
provide information about a
company’s performance

 The income statement reports on performance and the

elements of the income statement were defined in SFAC
No. 6 as:
 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:

Change in net economic Measure of

1. VS
resources effectiveness

2. Definition of Assets and Liabilities

Earnings VS Revenue & Expenses

Creation of deferred Recognition when they

3. VS
charges when measuring are economic resources
income or obligations
 Each Term Is Defined As Changes in
Assets and Liabilities

4. Both agree on importance of income statement

The change in asset

approach limits the
population from which The flows method
5. VS includes items
elements can be selected necessary to match
to net economic
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

= Income from continuing operations

Discontinued operations
Extraordinary items
Change in accounting principle

= Net income
 Income From Continuing Operations

 Normal and recurring revenues and expenses

 Sustainable income
 Income tax
 Nonrecurring items
 Discontinued operations
 Extraordinary items
 Change in accounting principle
Tootsie Roll and Hershey’s

 Tootsie Roll Industries and The Hershey Company

are internationally known candy manufacturers.

 We will use information from the two companies’ fiscal 2001 -

2005 annual reports to illustrate the disclosure of information
in this and subsequent chapters.
 Discontinued Operations
 Why special treatment?
 Arise from a disposal of a segment of a business
 Comprised of two elements
Gain or loss on disposed assets
Gain or loss on operations during the disposal periods
 When to report
Measurement date
Disposal date
 Neither Hershey’s nor Tootsie Roll disclosed any discontinued
operations for fiscal years 2003-2005
 Extraordinary Items
 Original definition
 Problems
 APB No. Opinion No. 30
Unusual nature
Infrequency of occurrence
 Problem:
 Requirements do not always separate recurring and non-recurring
items
 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
 Neither company discloses any extraordinary items for the years
presented
 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?
 Types of Accounting Changes
 Change in accounting principle
 How reported
 Best Buy changed its method of accounting for goodwill (discussed in
Chapter 10) and vendor allowances in fiscal 2003

 Change in accounting estimate

 How reported
 Change in accounting entity
 How reported
 Error
 How reported
 Earnings Per Share

 Basic calculation
Net income - Preferred dividends
Average # of common shares outstanding

 APB No. 15
 Simple vs. complex capital structure
 Required calculation of primary and fully diluted
earnings per share
 Criticism of APB No. 15
 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 Convertible securities
3 Continently 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
 Both Best Buy and Circuit City have complex capital structure
 disclose basic as well as diluted earnings per share on their their fiscal 2003
income statements
 SFAC No. 5 - Recognition and
Measurement

 Comprehensive income definition:

 The change in net assets of an entity from
non-owner transactions
 Attempts to combine Hicksian capital maintenance
approach with traditional accounting transactions
approach
 SFAC No. 5 - Recognition and
Measurement
 A full set of financial statements shall show:

Comprehensive
income
Investments
by and
Earnings distributions
to owners
 SFAS No. 5 - Recognition and
Measurement
Comprehensive income
Revenues Earnings
Less: Expenses Plus or minus cumulative accounting adjustments
Plus: Gains Plus or minus other nonowner
changes in equity
Less: Losses
= Earnings = Comprehensive income
 Measurement Issues
 Definitions.
 The item meets the definition of an element contained in SFAC No.
6.
 Measurability.
 It has a relevant attribute, measurable with sufficient reliability.
 Relevance.
 The information about the item is capable of making a difference in
user decisions.
 Reliability.
 The information is representationally faithful, verifiable, and
neutral.
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
 Allows for the disclosure of comprehensive
income
 On income statement
 On a separate statement
 On the statement of stockholders’ equity
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.
 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
 Financial Performance Reporting by
Business Enterprises
 In 2001 FASB initiated a project to
redesign the income statement.
 This project termed Financial Performance Reporting by
Business Enterprises has two main objectives:

1. To improve the quality of information

disclosed in financial statements to that
investors, creditors and other interested
parties are able to better evaluate an
enterprise’s financial performance
2. To ascertain that the financial statements
provide sufficient information to permit the
calculation of key financial performance
measures.
 Financial Performance Reporting by
Business Enterprises
 While no final conclusions had been drawn when this book was published,
some tentative decisions have been offered:
1. A single statement of comprehensive income should be prepared that reports all items of
revenue, expense, gains and losses.
2. The statement of comprehensive income should report three major categories
a. Business activities
b. Financing
c. Other
3. Income tax expense should be reported separately after the categories.
4. Income from continuing operations should be disclosed as a subtotal
5. Discontinued operations are to be presented as a separate classification net of their tax effects
after income tax expense.
6. Other comprehensive income is also presented
7. The cumulative effect of a change in accounting principle is included in other comprehensive
income.
8. Extraordinary items will be reported in the appropriate major category before tax and will not be
labels as extraordinary.
 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’s 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% 124.5%
100% 116.9%
120%
100%
100%
80%
60%
40%
20%
0%
2001 2002 2003 2004 2005
Hershey's Tootsie
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.
 Examples of these disclosures include
 unusual events
 expected future changes in revenues and expenses
 the factors that caused current revenues and expenses to increase or
decrease
 trends not otherwise apparent from a review of the company’s
financial statements
 An expanded discussion of the MD&A section of the annual
report is contained in Chapter 17.
Gross Profit Analysis
Gross Profit Percentage = Gross profit ÷ net sales
5-Year Gross Profit Trend Analysis

50.0%
44.4% 43.5% 43.3% 41.8% 38.7%
39.5% 38.7%
40.0% 35.5% 37.8% 39.0%

30.0%
20.0%
10.0%
0.0%
2001 2002 2003 2004 2005

Hershey's Tootsie
Net Profit Analysis
Net Profit Percentage = Net Income ÷ Net Sales
5-Year Net Profit Trend Analysis

20%
17% 17% 17%
15% 16%
15% 13%
11%
10%
10% 9%

5%
5%

0%
2001 2002 2003 2004 2005

Hershey's Tootsie
 The Value of Corporate
Earnings
The relationship between corporate earnings
and stock prices
Measured by price earnings ratio

Net Profit Percentage = Net Income ÷ Net Sales

Hershey’s = 26.69
Tootsie = 20.09
 International Accounting Standards

 International Accounting Standards Committee 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 Defined the concept of revenue in IAS No. 18, “Revenue”
5 Amended IAS No. 33
6 Discussed the required presentation and disclosure of a discontinued operation in
IFRS No. 5, “Non-Current Assets Held for Sale and Discontinued Operations”
IASC Definitions of Performance and Income

Profit is used
to measure performance
or as the basis for other measures
Measurement of income is
dependent on
the concept of capital maintenance
used by the enterprise
 Physical capital maintenance
 Financial capital maintenance
 IASC Definitions of Performance and Income

 The IASC definition of income

encompasses both revenue and
expenses
 The IASC has not made the
distinction between ordinary and
nonordinary operations contained in
SFAC No. 6
 A proposed standard would require a “Statement of
Non-owner Movements in Equity”
 Encourages an analysis of income and expenses based
on their nature or function in the enterprise
 IAS No. 1: Presentation of Financial Statements

 Requires an operating/non operating separation and disclosure of the

following components of income:
 Revenue
 Results of operating activities
 Finance costs
 Income from associates and joint ventures
 Taxes
 Profit or loss from ordinary activities
 Extraordinary items
 Minority interest
 Net profit or loss

 FASB Staff Reaction

 IAS No. 8: Accounting Policies, Changes in
Accounting Estimates and Errors

 Originally, IAS No. 8

 defined the concepts of

 net profit or loss from ordinary activities

 extraordinary items
 accounting changes
 fundamental errors
 Each of these income statement items was
defined and reported in a manner similar to U.S. GAAP
 with the exception of fundamental errors

 The revised IAS No. 8

 does not distinguish between ordinary and extraordinary items

 eliminates the concept of fundamental errors

IAS No. 8: Accounting Policies, Changes in
Accounting Estimates and Errors
A GAAP hierarchy indicates that the following sources must
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
 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
 FASB Staff Reaction
 IAS No. 18 - Revenue
 Revenue should be recognized when:
1 The enterprise has transferred to the buyer
the significant risks and rewards of
ownership of goods
2 The enterprise doesn’t retain managerial
involvement or control over the goods sold
3 The amount can be measured reliably
4 It is probable that economic benefits associated with
the transaction will flow to the enterprise
5 The costs associated with the transaction can be
measured reliably
 IAS No. 18 - Revenue
 U. S. GAAP does not specifically address the issue of
revenue
 If it did, there would probably be a difference because of the
IASC use of the term probable future economic benefit
 FASB Staff Reaction
 IAS No. 35: Discontinued Operations

 The amended IAS No. 33 incorporated the following additional

disclosures and guidelines:
1. Basic and diluted EPS must be presented for
(a) profit or loss from continuing operations and
(b) net profit or loss
…on the face of the income statement for each
class of ordinary shares, for each period
presented.
2. Potential ordinary shares are dilutive only when their
conversion to ordinary shares would decrease EPS from
continuing operations
(IAS 33 previously used net income as the benchmark).
 IAS No. 35: Discontinued Operations

3. For contracts that may be settled in cash or

shares, now includes a rebuttable presumption
that the contract will be settled in shares.
4. If an entity purchases (for cancellation) its own
preference shares for more than their carrying
amount, the excess (premium) should be treated
as a preferred dividend in calculating basic EPS (deducted from the
numerator of the EPS computation).
5. Guidance is provided on how to calculate the effects of contingently
issuable shares; potential ordinary shares of subsidiaries, joint ventures,
or associates: participating securities; written put options; and purchased
put and call options.
 IFRS No. 5: Non-Current Assets Held for
Sale and Discontinued Operations

 SFRS No. 5 replaces IAS No. 35.

 Discontinued operations

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

or loss of the
discontinued
operation
+
loss recognized
on the
measurement to
fair value
- fair 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.
 Prepared by
Richard Schroeder, PhD
Kathryn Yarbrough, MBA

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