Income Statement and Related Information

Chapter

4

Chapter 4-1

Income Statement Usefulness
Relevance

Evaluate past performance (feedback).
Predicting future performance. Help assess the risk or uncertainty of achieving future cash flows. (conceptual framework objective)

Chapter 4-2

Income Statement Limitations
Faithful Representation

Companies omit items that cannot be measured reliably.
Allowing choice/discretion can help but is not always good Income is affected by the accounting methods employed and judgments of managers.

Chapter 4-3

Income Statement Limitations
Quality of Earnings may be reduced when CEO’s
have incentives to manage income for personal gain which may not align with providing most decision useful information. Potential misalignment due to:
Stock options.
Beating earnings expectations is positively related to market value of stock price Bonuses for reaching earnings levels set by company boards

Chapter 4-4

Elements of the Income Statement
Revenues – Inflows or other enhancements of assets
or settlements of its liabilities that constitute the entity’s ongoing major or central operations.
Examples of Revenue Accounts

Sales Fee revenue Interest revenue Dividend revenue Rent revenue
Chapter 4-5

Elements of the Income Statement
Expenses – Outflows or other using-up of assets or
incurrences of liabilities that constitute the entity’s ongoing major or central operations.
Examples of Expense Accounts

Cost of goods sold Depreciation expense Interest expense Rent expense Salary expense
Chapter 4-6

Elements of the Income Statement
Gains – Increases in equity (net assets) from
peripheral or incidental transactions.
peripheral or incidental transactions.

Losses - Decreases in equity (net assets) from
Gains and losses can result from sale of investments or plant assets, settlement of liabilities, write-offs of assets.

Chapter 4-7

Single-Step Income Statement
The single-step statement consists of just two groupings: Revenues
SingleStep
Income Statement (in thousands) Revenues: Sales Interest revenue Total revenue Expenses: Cost of goods sold Advertising expense Depreciation expense Interest expense Income tax expense Total expenses Net income Earnings per share 149,000 10,000 43,000 21,000 23,700 246,700 $ 55,300 $ 0.75 $ 285,000 17,000 302,000

Expenses
Net Income

No distinction between Operating and Non-operating categories.
Chapter 4-8

E4-4: Prepare an income statement from the data below.
Administrative expense: Officers' salaries Depreciation Cost of goods sold Rental revenue Selling expense: Transportation-out Sales commissions Depreciation Sales Income tax expense Interest expense 2,690 7,980 6,480 96,500 7,580 1,860 $ 4,900 3,960 63,570 17,230

Single-Step Format
Income Statement For the year ended Dec. 31, 2011 Revenues: Sales Rental revenue Total revenues Expenses: Cost of goods sold Selling expense Administrative exense Interest expense Income tax expense Total expenses Net income $ 63,570 17,150 8,860 1,860 7,580 99,020 14,710 $ 96,500 17,230 113,730

Chapter 4-9

Multiple-Step Income Statement
The presentation divides information into major sections.
1. Operating Section 2. Nonoperating Section 3. Income tax
Income Statement (in thousands) Sales Cost of goods sold Gross profit Operating expenses: Advertising expense Depreciation expense Total operating expense Income from operations Other revenue (expense): Interest revenue Interest expense Total other Income before taxes Income tax expense Net income
Chapter 4-10

$ 285,000 149,000 136,000 10,000 43,000 53,000 83,000 17,000 (21,000) (4,000) 79,000 23,700 $ 55,300 $ 0.75

Earnings per share

Illustration (E4-4): Prepare an income statement from the data below.
Administrative expense: Officers' salaries Depreciation Cost of goods sold Rental revenue Selling expense: Transportation-out Sales commissions Depreciation Sales Income tax expense Interest expense 2,690 7,980 6,480 96,500 7,580 1,860 $ 4,900 3,960 63,750 17,230

Multiple-Step Format
Income Statement For the year ended Dec. 31, 2011 Sales Cost of goods sold Gross profit Operating Expenses: Selling expense Administrative exense Total operating expenses Income from operations Other revenue (expense): Rental revenue Interest expense Total other Income before tax Income tax expense Net income $ 17,230 (1,860) 15,370 22,110 7,580 14,530 17,150 8,860 26,010 6,740 $ 96,500 63,750 32,750

Chapter 4-11

Income Statement Formats
Single Step

Used mainly by service firms, banks, utilities
Multiple Step

Used mainly by merchandising and manufacturing firms

Chapter 4-12

Earnings Per Share
Basic EPS Calculation
Net income - Preferred dividends
Weighted average number of shares outstanding Diluted EPS – takes account of potential dilution from options, convertible debt or preferred stock

EPS to be reported for continuing operations, each of the non-continuing operations account, and net income.

Chapter 4-13

Earnings Per Share
Exercise In 2007, Kirby Puckett Corporation reported net income of $1,200,000. It declared and paid preferred stock dividends of $250,000. Puckett had 280,000 common shares outstanding at 2007 year end (500,000 shares authorized) of which 100,000 common shares were outstanding the whole year and 180,000 outstanding since June 30. Compute Puckett’s 2007 earnings per share.

Chapter 4-14

Special Reporting Issues

Present EPS information for Continuing, Discontinued, and Extraordinary Sections.
(Note: Preferred dividends are deducted from Income from continuing operations)

Chapter 4-15

EPS Info

Reporting Irregular (non-continuing) Items
Companies are required to report irregular items in the financial statements so users can better understand the long-run earnings power of the company.

Chapter 4-16

Reporting Irregular Items
Irregular items fall into six categories
Discontinued operations.
Extraordinary items. Unusual gains and losses. Changes in accounting principle. Changes in estimates. Corrections of errors.

Chapter 4-17

Reporting Irregular Items
Discontinued Operations occurs when,
(a) company eliminates the
results of operations and cash flows of a component.
(b)

there is no significant continuing involvement in that component.

Amount reported “net of tax.”
See FASB Codification 205 20
Chapter 4-18

Reporting Discontinued Operations
Exercise: McCarthy Corporation had after tax income from continuing operations of $55,300,000 in 2007. During 2007, it disposed of its restaurant division at a pretax loss of $270,000. Prior to disposal, the division operated at a pretax loss of $450,000 in 2007. Assume a tax rate of 30%. Prepare a partial income statement for McCarthy.
Income from continuing operations Discontinued operations: Loss from operations, net of $________ tax Loss on disposal, net of $_________ tax Total loss on discontinued operations Net income
Chapter 4-19

Reporting Discontinued Operations
Discontinued Operations are reported after “Income from continuing operations.”
Income Statement (in thousands) Sales Cost of goods sold
Other revenue (expense): Interest revenue Interest expense Total other Income before taxes 17,000 (21,000) (4,000) 79,000 23,700 55,300 315 189 504 $ 54,796

$ 285,000 149,000

Previously labeled as “Net Income”.

Income tax expense Income from continuing operations Discontinued operations: Loss from operations, net of tax Loss on disposal, net of tax

Moved to
Chapter 4-20

Total loss on discontinued operations Net income

Reporting Irregular Items
Extraordinary items are nonrecurring material
items that differ significantly from a company’s typical business activities.
Extraordinary Item must be both of an
Unusual Nature and Occur Infrequently

Company must consider the environment in which it operates. Amount reported “net of tax.”
Chapter 4-21

Reporting Extraordinary Items
Are these items Extraordinary? CA 3

Chapter 4-22

Reporting Extraordinary Items
Exercise: McCarthy Corporation had after tax income from continuing operations of $55,300,000 in 2007. In addition, it suffered an unusual and infrequent pretax loss of $770,000 from a volcano eruption. The corporation’s tax rate is 30%. Prepare a partial income statement for McCarthy Corporation beginning with income from continuing operations.
Income from continuing operations Extraordinary loss, net of$__________tax

Net income

Chapter 4-23

Reporting Extraordinary Items
Extraordinary Items are reported after “Income from continuing operations.”
Income Statement (in thousands) Sales Cost of goods sold $ 285,000 149,000

Previously labeled as “Net Income”. Moved to

Other revenue (expense): Interest revenue Interest expense Total other Income before taxes Income tax expense Income from continuing operations Extraordinary loss, net of tax Net income $

17,000 (21,000) (4,000) 79,000 23,700 55,300 539 54,761

Chapter 4-24

Reporting Irregular Items
Reporting when both Discontinued Operations and Extraordinary Items are present.
Income Statement (in thousands) Sales Cost of goods sold
Interest expense Total other Income before taxes Income tax expense Income from continuing operations Discontinued operations: Loss from operations, net of tax Loss on disposal, net of tax Total loss on discontinued operations Income before extraordinary item Extraordinary loss, net of tax Net income
Chapter 4-25

$ 285,000 149,000
(21,000) (4,000) 79,000 23,700 55,300 315 189 504 54,796 539 $ 54,257

Discontinued Operations Extraordinary Item

Intraperiod Tax Allocation
Relates the income tax expense to the specific items that give rise to the amount of the tax expense. Income tax is allocated to the following items: (1) Income from continuing operations before tax (2) Discontinued operations (3) Extraordinary items (4) Changes in accounting principle (5) Correction of errors

Chapter 4-26

Example of Intraperiod Tax Allocation
Income Statement (in thousands) Sales Cost of goods sold Note:
Interest expense Total other Income from cont. oper. before taxes Income tax expense Income from continuing operations Discontinued operations: Loss on operations, net of $135 tax Loss on disposal, net of $81 tax Total loss on discontinued operations Income before extraordinary item Extraordinary loss, net of $231 tax Net income 315 189 504 54,796 539 $ 54,257

losses reduce the total tax

$ 285,000 149,000
(21,000) (4,000) 79,000 23,700 55,300

Total Tax Allocated $23,700
(135) (81) (231) $23,253

Chapter 4-27

Reporting Irregular Items
Unusual Gains and Losses
Material items that are unusual or infrequent, but not both, should be reported in a separate section just above “Income from continuing operations before income taxes.”

Examples can include:
Write-downs of inventories Foreign exchange transaction gains and losses The Board prohibits net-of-tax treatment for these items.
Chapter 4-28

Reporting Irregular Items
Changes in Estimate
Accounted for in the period of change and future periods Not handled retrospectively Not considered errors or extraordinary items Examples include:
 Useful lives and salvage values of depreciable

assets

 Allowance for uncollectible receivables

 Inventory obsolescence
Chapter 4-29

Change in Estimate Example
Arcadia HS, purchased equipment for $510,000 which was estimated to have a useful life of 10 years with a salvage value of $10,000 at the end of that time. Depreciation has been recorded for 7 years on a straight-line basis. In 2005 (year 8), it is determined that the total estimated life should be 15 years with a salvage value of $5,000 at the end of that time. Questions:  What is the journal entry to correct the prior years’ depreciation?  Calculate the depreciation expense for 2005.
Chapter 4-30

Change in Estimate Example

After 7 years

Chapter 4-31

Reporting Irregular Items
Changes in Accounting Principles
Retrospective adjustment Cumulative effect adjustment to beginning retained earnings of earliest year presented Approach preserves comparability Examples include:
 change from FIFO to average cost  change from the percentage-of-completion to

the completed-contract method

Chapter 4-32

Reporting Irregular Items
Change in Accounting Principle: Gaubert Inc. decided in
March 2010 to change from FIFO to weighted-average inventory pricing. Gaubert’s income before taxes, using the new weightedaverage method in 2010, is $30,000.
Pretax Income Data

Illustration 4-10

Calculation of a Change in Accounting Principle

Illustration 4-11

Income Statement Presentation of a Change in Accounting Principle (Based on 30% tax rate) Chapter 4-33

Reporting Irregular Items
Corrections of Errors
Result from:
mathematical mistakes  mistakes in application of accounting principles  oversight or misuse of facts

Corrections treated as prior period adjustments restate all prior financial statements presented

Chapter 4-34

Retained Earnings
Changes in Retained Earnings

Increase
Net income Change in accounting principle Error corrections

Decrease
Net loss Dividends Change in accounting principles Error corrections

Chapter 4-35

Exercise 4-11 (assume no comparative financial statements)

Chapter 4-36

Comprehensive Income
All changes in equity during a period except those resulting from investments by owners and distributions to owners.
Income Statement (in thousands) Sales Cost of goods sold Gross profit Operating expenses: Advertising expense Depreciation expense Total operating expense Income from operations Other revenue (expense): Interest revenue Interest expense Total other Income before taxes Income tax expense Net income
Chapter 4-37

$ 285,000 149,000 136,000 10,000 43,000 53,000 83,000 17,000 (21,000) (4,000) 79,000 24,000 55,000

+

Other Comprehensive Income

Unrealized gains and losses on availablefor-sale securities. Translation gains and losses on foreign currency. Plus others Reported in Stockholders’ Equity

$

Other Comprehensive Income
 

OCI presented as net of tax. OCI is also reported in the Stockholder’s Equity section in the balance sheet

Chapter 4-38

Reporting Comprehensive Income
FASB’s new guidance requires companies to present OCI in one of two ways:
• Present OCI in a single continuous statement of comprehensive income that lists the components of net income and total net income, the components of OCI and total OCI, and the total of CI. Take a two-statement approach: • An income statement presenting the components of net income and total net income, and • A statement of OCI (immediately following the income statement) must present the components of OCI, a total for OCI and a total for CI. • The second statement may begin with net income.

Chapter 4-39

Comprehensive Income
Balance Sheet Presentation

Regardless of the display format used, the accumulated other comprehensive income of $90,000 is reported in the stockholders’ equity section of the balance sheet.
Chapter 4-40

Under iGAAP, companies must classify expenses by either nature or function. If a company uses the functional expense method on the income statement, disclosure by nature is required in the notes to the financial statements. (SEC requires functional expense method)

Presentation of the income statement under U.S. GAAP follows either a single-step or multiple-step format. iGAAP does not mention a single-step or multiple-step approach. In addition, under U.S. GAAP, companies must report an item as extraordinary if it is unusual in nature and infrequent in occurrence. Extraordinary items are prohibited under iGAAP.

Chapter 4-41

Both iGAAP and U.S. GAAP have items that are recognized in equity as part of comprehensive income but do not affect net income. U.S. GAAP provides two possible formats for presenting this information. iGAAP provides the statement of recognized income and expense (SoRIE) format. Under iGAAP revaluation of land, buildings, and intangible assets is permitted (shown as an other comprehensive income adjustment).

Chapter 4-42

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