Chapter 4

THE INCOME STATEMENT

AND STATEMENT OF
CASH FLOWS

© 2013 The McGraw-Hill Companies, Inc.

 An income
statement for a
hypothetical
manufacturing
company that you
can refer to as we
proceed through
the chapter.

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 Income from Continuing Operations

Revenues Expenses Gains and Income Tax

Losses Expense
Inflows of Outflows of
resources resources Increases or Because of
resulting incurred in decreases in its
from generating equity from importance
providing revenues. peripheral or and size,
goods or incidental income tax
services to transactions expense is a
customers. of an entity. separate
item.
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 Operating versus Nonoperating Income

Operating Nonoperating
Income Income

Includes revenues Includes gains

and expenses and losses and
directly related to revenues and
the principal expenses related
revenue- to peripheral or
generating incidental
activities of the activities of the
company company

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 Income Statement (Single-Step)
Proper
Heading
Revenues
& Gains

Expenses
& Losses

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 Income Statement (Multiple-Step)
Proper
Heading
Gross
Profit
Operating
Expenses

Non-
operating
Items

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 U. S. GAAP vs. IFRS
There are more similarities than differences between
income statements prepared according to IFRS and
those prepared according to U.S. GAAP. Some
differences are highlighted below.

• Has no minimum requirements. • Specifies certain minimum

SEC requires that expenses be
classified by function.
• “Bottom line” called net income
or net loss.
• Report extraordinary items
separately.
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information to be reported on the
face of the income statement.
• Allows expenses classified by
function or natural description.
• “Bottom line” called profit or loss.
• Prohibits reporting extraordinary
items.
 Earnings Quality

Earnings quality refers to the ability of

reported earnings to predict
a company’s future earnings.

Transitory Earnings
versus
Permanent Earnings

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 Manipulating Income and
Income Smoothing

“Most executives prefer to report earnings

that follow a smooth, regular, upward path.”
~Ford S. Worthy, “Manipulating Profits: How It’s Done”, Fortune

Two ways to manipulate

income:
1. Income shifting
2. Income statement
classification
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 Operating Income and Earnings Quality
Costs associated with shutdown or
relocation of facilities or
Restructuring Costs downsizing of operations are
recognized in the period incurred.

Goodwill Impairment
Involves asset impairment losses
and Long-lived Asset or charges.
Impairment

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 Nonoperating Income and
Earnings Quality
Gains and losses generated from the sale of
investments often can significantly inflate or
deflate current earnings.

Example How should those

As the stock market boom reached gains be interpreted
its height late in the year 2000, in terms of their
many companies recorded large relationship to
gains from sale of investments future earnings?
that had appreciated significantly Are they transitory
in value. or permanent?

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 Separately Reported Items
Reported separately, net of taxes:
Discontinued Extraordinary items
operations (under U.S. GAAP, but not IFRS)

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 Intraperiod Income Tax Allocation
Income Tax Expense must be associated with
each component of income that causes it.

Show Income Tax Report effects of

Expense related to Discontinued Operations net
Income from Continuing of related income tax effect.
Operations.

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 Reporting Discontinued Operations
The IASB and FASB have been working together to
develop a common definition and a common set of
disclosures for discontinued operations.

The proposed standard defines a

discontinued operation as a “component”
that either:
1.Has been disposed of
2.Is classified as held for sale

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 Reporting Discontinued Operations
Reporting for Components Sold
Income or loss from
operations of the Gain or loss on the
component from the disposal of the
beginning of the reporting component’s assets.
period to the disposal date

Reporting for Components Held For Sale

Income or loss from
operations (revenues,
expenses, gains, and
losses) of the component
from the beginning of the
reporting period to the end
of the reporting period
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An “impairment loss” if
the carrying value of
the assets of the
component is more
than the fair value
minus cost to sell.
 Unusual or Infrequent Items

Unusual or infrequent items that are

material are included as separate
component of continuing operations or
disclosed in notes to financial statements

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 Accounting Changes

Type of Accounting
Change Definition
Change in Accounting Change from one acceptable
Policy accounting method to another
Change in Accounting Revision of an estimate
Estimate because of new information or
new experience

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 Change in Accounting Policies
• A change in accounting policy refers to a change
from one acceptable accounting method to
another.

• IFRS requires that voluntary changes in accounting

policy be accounted for retrospectively by revising
prior years’ financial statements.

• For mandated changes in accounting policies,

companies are required to account for the change
according to the requirements in that new or
updated standard. If not specified, companies are
required to account for the change retrospectively.

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 Change in Depreciation or Amortization
Method

A change in depreciation,
or amortization method is
treated the same as a
change in accounting
estimate.

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 Change in Accounting Estimate
Revision of a previous
accounting estimate

Use new estimate in

current and future
periods

Includes changes in
depreciation or
amortization methods
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 Correction of Accounting Errors
Errors occur when transactions are either
recorded incorrectly or not recorded at all.

Errors Reverse original erroneous journal

Discovered in entry and record the appropriate
Same Year journal entry.

Record a prior period adjustment to

the beginning retained earnings
Material Errors balance in a statement of changes in
shareholders’ equity.
Discovered in
Subsequent Previous years’ financial statements
Year that are incorrect as a result of the
error are retrospectively restated to
reflect the correction.
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 Earnings per Share Disclosure
One of the most widely used ratios is earnings per
share (EPS), which shows the amount of income
earned by a company expressed on a per share basis.

Basic EPS Diluted EPS

Reflects the potential dilution that could

Net income less preference dividends occur for companies that have certain
Weighted-average number of ordinary securities outstanding that are convertible
into ordinary shares or share options that
shares outstanding for the period
could create additional ordinary shares if the
options were exercised.

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 Earnings per Share Disclosure

Report EPS data separately for:

1. Income (loss) from continuing
operations
2. Income (loss) from discontinued
operations
3. Net Income (loss)

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 Comprehensive Income

An expanded
version of income
that includes gains
and losses that
traditionally have
not been included
in income
statements.

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 Other Comprehensive Income
Comprehensive income includes traditional net income
as well as additional gains and losses that change
shareholders’ equity.
1. Net unrealized gains (losses) from investments (net of tax).
2. Gains and losses due to reviewing assumptions or market returns
differing from expectations and prior service cost from amending the
postretirement benefit plan.
3. When a derivative designated as a hedging instrument for a cash
flow hedge is adjusted to fair value, the gain or loss is deferred as a
component of comprehensive income and included in earnings later,
at the same time as earnings are affected by the hedged transaction.
4. Gains or losses from changes in foreign currency exchange rates.
The amount could be an addition to or reduction in shareholders’
equity. (This item is discussed elsewhere in your accounting
curriculum).
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 U. S. GAAP vs. IFRS
Both IFRS and U.S. GAAP allow companies to report income
and other comprehensive income items in either a single,
continuous statement of comprehensive income or in two
separate, but consecutive statements (an income statement
and a statement of comprehensive income).

• Similar OCI items as IFRS. • Similar OCI items as U.S.

GAAP
• Additional OCI item: changes in
revaluation surplus, from the
optional revaluation of property,
plant, and equipment and
intangible assets.
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 Accumulated Other Comprehensive Income
In addition to reporting OCI that occurs in the current
reporting period, U.S. GAAP requires companies to report
OCI on a cumulative basis in the statement of financial
position. IFRS does not require companies to report
accumulated other comprehensive income (AOCI).

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 Flexibility in Reporting

The information in the income statement and other

comprehensive income items can be presented either:
1) in a single, continuous statement of comprehensive
income or
2) in two separate, but consecutive statements, an
income statement and a statement of comprehensive
income

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 The Statement of Cash Flows
• Provides relevant information about a company’s
cash receipts and cash disbursements.

• Helps investors and creditors to assess

 future net cash flows
 liquidity
 long-term solvency.

• Required for each income statement period

reported.

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 Operating Activities

Inflows from:
 sales to customers.
 interest and dividends
received from investments. + Cash
Flows
Outflows for: from
 purchase of inventory. Operating
 salaries, wages, and other _ Activities
operating expenses.
 interest on debt.
 income taxes.
 dividends paid.
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 Direct and Indirect Methods of
Reporting
Two Formats for Reporting Operating Activities

Direct Method Indirect Method

Reports the Starts with

cash effects of accrual net
each operating income and
activity converts to
cash basis

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 Direct Method
Under the direct method, the cash effect of each
operating activity is reported directly in the
statement.

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 Indirect Method
By the indirect method, we arrive at net cash flow from
operating activities indirectly by starting with reported net
income and working backwards to convert that amount to a
cash basis.

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 Investing Activities
Inflows from:
 sale of long-lived assets used in the
business.
 sale of investment securities (shares
and bonds).
 collection of nontrade receivables.
+ Cash
 interest or dividends received from Flows
investments.
from
Outflows for: Investing
 purchase of long-lived assets used _
in the business. Activities
 purchase of investment securities
(shares and bonds).
 loans to other entities.
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 Financing Activities

Inflows from:
 sale of shares to owners.
 borrowing from creditors
through notes, loans, + Cash
mortgages, and bonds. Flows
from
Outflows for: Financing
 owners for the repurchase or reacquisition _
of shares previously sold. Activities
 owners in the form of dividends or other
distributions .
 creditors for the repayment of the principal
amounts of debt.
 creditors for the payment of interest on
debt
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 ALC’s Statement of Cash Flows

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 Noncash Investing and Financing
Activities
Significant investing and financing
transactions not involving cash
also are reported.
Acquisition of equipment (an investing
activity) by issuing a long-term note
payable (a financing activity).

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 U. S. GAAP vs. IFRS
Both U.S. GAAP and IFRS require a statement of cash flows
and classify cash flows as operating, investing, or financing.

Typical Classification of Cash Flows from

Interest and Dividends

• Operating Activities • Operating Activities

– Dividends Received
– Interest Received
– Interest Paid • Investing Activities
• Investing Activities – Dividends Received
– Interest Received
• Financing Activities
• Financing Activities
– Dividends Paid
– Dividends Paid
– Interest Paid
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 U. S. GAAP vs. IFRS
The FASB and IASB are working together on a project,
Financial Statement Presentation, to establish a common
standard for presenting information in the financial
statements.

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 End of Chapter 4

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