Chapter 4

Income Statement
Basic Elements of Income Statement
 The Income Statement

• Dated for a period of time

– For the Year Ended...
• Multiple-step format
– Gross profit
– Operating income
– Income before taxes
– Net income
• Single-step format
– Total of all revenues and gains
– Less the total of all expenses and losses
 Multiple-Step Single Step
Multiple-Step Company Single-Step Company
Income Statement Income Statement
For the Year Ended December 31, 20XX For the Year Ended December 31, 20XX

Net revenue $37,586 Net revenue $ 37,586

Cost of sales 16,742 Interest income 488
Gross margin 20,844 Other income -
Operating Expenses:
General & administrative $ 5,458
38,074
Resaarch & development 5,722 Costs and Expenses:
Restructuring charges 710 11,890 Cost of sales $ 16,742
Operating income 8,954 General & administrative 5,458
Interest income (expense) 488 Research & development 5,722
Other gains (losses) (net) (1,756) (1,268) Other losses 1,756
Income before taxes 7,686 Restructuring charges 710 30,388
Provision for taxes 2,394
Income before taxes 7,686
Net Income $ 5,292
Provision for taxes 2,394
Net income $ 5,292
Basic Elements of the Income Statement

• Net Sales (Revenues)

• Cost of Goods Sold (Cost of Sales)
• Other Operating Revenue
• Research and Development
• Restructuring Charges
• Impairment Charges
• Operating Expenses
• Depreciation and Amortization
• Other Income or Expense ( gains or losses)
 Net Sales

• Revenue from the sale of principal goods or

services sold to customers
• Shown net of
– Discounts
– Returns
– Allowances
 Cost of Goods Sold

• The cost of goods that were sold to produce revenue

(cost of services in a service company)

Retailer Manufacturer
Beginning Inventory Beginning Inventory
+ Purchases + Cost of Goods
Manufactured
– Ending Inventory
– Ending Inventory
= Cost of Goods Sold
Service Company = Cost of Goods Sold

Will have Cost of

Services
 Other Operating Revenue

• Reflects the nature of the business

• Examples
– Lease revenue
– Royalty revenue
– Finance charges
– Commission revenue
 Operating Expenses

• Selling expenses
– Result from the company’s effort to create sales
– Examples
• Advertising
• Sales commissions
• Sales supplies used
• Administrative expenses
– Relate to the general administration of the
company’s operation
– Examples
• Salaries
• Insurance
• Bad debt expense
 Other Income or Expense

• Secondary activities not directly related to

operations
– Dividend income
– Interest income
– Gains (losses) from sale of assets
– Interest expense
 Special Income Statement Items

• (A) Unusual or Infrequent Items Disclosed

Separately (e.g. Gain on sale of securities,
write-downs of A/R or write-downs of inventory)
– Included with normal recurring revenues and
expenses
– If material, disclosed separately, before income taxes
– Relate to operations
– Treatment for analysis
• Primary analysis: include
• Supplementary analysis: exclude
Special Income Statement Items (cont’d)

• (B) Equity in Earnings of Nonconsolidated

Subsidiaries
– The investor’s proportional share of the investee’s
net income
– Does not represent cash flow to the investor
• Cash dividends received represent cash flow
– Analysis issues:
• Investor’s net income includes revenue of other entity
• May distort ratios
• Presented before tax; tax consequences typically
immaterial
Special Income Statement Items (cont’d)

• Income Taxes Related to Operations

– Federal, state, and local
– Includes both paid and deferred taxes
• (C) Discontinued Operations
– Reported net of income tax, shown after income
taxes
– Analysis issues:
• Inadequate disclosure of associated assets
• Lack of historical profit and loss information on the
discontinued operations
Special Income Statement Items (cont’d)

• (D) Extraordinary Items

– Unusual and infrequent i.e fire, flood, earthquake,
expropriation
– Reported net of income tax (listed after income tax)
– Analysis issues:
• Exclude from primary analysis
• Include for supplementary analysis

• GAAP & IFRS no longer has Extraordinary items now is Infrequent

and nonrecurring. For GAAP Must be either in income statement or
disclosed in the notes. For IFRS is included in income statement
under normal headings.
Special Income Statement Items (cont’d)
• (E) Cumulative Effect of a Change in Accounting
Principle
– For fiscal years beginning before 12/15/05
• Cumulative effect of the change shown net of tax on the income
statement of the period in which change was made
• Earlier statements not restated to reflect application of the new
principle
– Effective for fiscal years beginning after 12/15/05
• All comparative statements are retrospectively restated to reflect
application of the new accounting principle
• The cumulative effect on income of earlier years is shown as a
net-of-tax adjustment to the beginning Retained Earnings balance
of the earliest period presented
Special Income Statement Items (cont’d)

• (F) Net Income-Noncontrolling Interest (prior to

Dec. 31,2009 is was called Minority Share of
Earnings)
– Earnings of a partially-owned consolidated subsidiary that would
accrue to the minority owners
– Presentation may be either pre-tax or net-of-tax, shown after
taxes
• Earnings per Share
Net income ÷ Number of shares outstanding
IFRS
Percent of “Profit for the Year” that belongs to another company
is deducted on Income Statement and in the Statement of
changes in Equity not included but disclosed.
Reconciliation of Retained Earnings

Reported as part of the Statement of Stockholders’

Equity or combined with the Income Statement

Beginning of year balance of retained earnings

+ Prior period adjustments (net of tax)
± Cumulative effect of a change in accounting principle
(net of tax)
= Beginning balance as adjusted
+ Net income
– Dividends
= End-of-year balance of retained earnings
 Retained Earnings

• The accumulated undistributed earnings of the

corporation reported on the balance sheet
• Appropriated
– Restricted by law, contract, or management decision
– Not available for dividends
– Called reserves in IFRS
• Unappropriated
– Available for dividends
– Does not represent cash or any other asset
 Stock Dividends

• Cash dividends
– Date of declaration: create liability and reduce retained
earnings
– Date of payment: reduce liability and cash
• Stock dividends
– Small (less then 25%): capitalize the market value of the stock, meaning remove
from retained earnings and transfer to paid-in capital the fair market value of the
stock.
– Material: capitalize the par value of the stock, meaning transfer as above is at par
value of shares.
– Total equity is unaffected by a stock dividend
– Analysis issues:
• Restate share quantities to reflect stock dividend activity
 Stock Dividend Example

100,000 shares outstanding; $1 par; $5 market

10% s to c k dividend 40% s toc k dividend
B efore effec t of dividend balanc e after effec t of dividend balanc e after
C om m on s toc k par value $1.00 $1.00 $1.00
S hares outs tanding 100,000 is s ue 10,000 s h 110,000 is s ue 40,000 s h 140,000
Total par value $100,000 10,000 $110,000 40,000 $140,000
A dditional paid-in c apital 750,000 40,000 790,000 750,000
Total paid-in c apital 850,000 900,000 890,000
R etained earn ings 1,000,000 (50,000) 950,000 (40,000) 960,000
Total s toc k holders ' equity $1,850,000 $1,850,000 $1,850,000

10% stock dividend 40% stock dividend

on 100,000 shares: on 100,000 shares:
issue 10,000 issue 40,000
additional shares additional shares
recorded at $5 per recorded at $1 per
share share
 Stock Splits

• 2-for-1 split
– Doubles the quantity of stock
– Par or stated value is halved
• No effect on retained earnings, additional paid-
in capital, or capital stock accounts
• Analysis issues:
– Restate share quantities to reflect split activity
Legality of Distributions to Shareholders

• Per various state laws

– Distributions are acceptable as long as the firm has
the ability to pay debts as they come due in the
normal course of business
– Distributions to stockholders are acceptable as long
as the firm is solvent and the distributions do not
exceed the fair value of the assets
– Distributions consist of solvency and balance sheet
test of liquidity and risk
 Comprehensive Income
Net income
+ The period’s change in accumulated other comprehensive income
= Comprehensive income

• Foreign currency translation adjustments

• Unrealized holding gains and losses on available-for-sale marketable securities
• Changes to stockholders’ equity resulting from additional minimum pension liability adjustments
• Unrealized gains and losses from derivative instruments
 Comprehensive Income (cont’d)

• Required disclosures
– Comprehensive income
– Other comprehensive income from each category
– Reclassification adjustments for each category of
other comprehensive income
– Tax effects for each category of other
comprehensive income
– Balances for each category of other comprehensive
income
 Comprehensive Income –
Combined with Income Statement
XYZ Corporation
Statement of Income and Comprehensive Income
For the Year Ended December 31, 20XX

Sales $ 230,000
Cost of goods sold 140,000
Gross profit 90,000
Operating expenses 40,000
Operating income 50,000
Other income 4,000
Income before income taxes 54,000
Income taxes 20,000
Net income 34,000
Other comprehensive income
Available-for-sale security adjustment, net of tax 5,500
Minimum pension liability adjustment, net of tax 3,500
Foreign currency transaction adjustment, net of tax (5,000)
Other comprehensive income 4,000
Comprehensive income $ 38,000

Earnings per share (for net income only) $ 2.80

 Comprehensive Income –
Separate Statement
XYZ Corporation
Statement of Comprehensive Income
For the Year Ended December 31, 20XX

Net income $ 34,000

Other comprehensive income
Available-for-sale security adjustment, net of tax 5,500
Minimum pension liability adjustment, net of tax 3,500
Foreign currency transaction adjustment, net of tax (5,000)
Total other comprehensive income 4,000
Comprehensive income $ 38,000
 Comprehensive Income (cont’d)

• Presentation
– In a separate financial statement
– Combined with the income statement
– As part of the schedule of changes in stockholders’
equity
Comprehensive Income – As Part of the
Statement of Stockholders’ Equity
XYZ Corporation
Statement of Changes in Stockholders' Equity
For the Year Ended December 31, 20XX

Accumulated
Other
Retained Comprehensive Common Stock
Total Earnings Income Amount Shares
Beginning Balance $180,000 $60,000 $10,000 $110,000 55,000
Net Income 34,000 34,000
Available-for-sale
security adjustment,
net of tax 5,500 5,500
Minimum pension
liability adjustment, net
of tax 3,500 3,500
Foreign currency
transaction adjustment,
net of tax (5,000) (5,000)
Comprehensive income 38,000
Ending Balance $218,000 $94,000 $14,000 $110,000 55,000
 Comprehensive Income (cont’d)

• Analysis issues:
– Typically more volatile than net income
– A better indication of long-run profitability
 Income Statement IFRS vs GAAP

• Income Statements are similar with some

presentation differences
-IFRS has no required format of the Income
Statement.
-IFRS equipment may be revalued which has
impact on depreciation expense
-IFRS allows for alternative performance
measures to be presented in Income
Statement.