wiley - chapter 4: income statement and related information

Chapter 4-1

Income Statement and Income Statement and Related InformationRelated Information

Income Statement and Income Statement and Related InformationRelated Information

ChapteChapter r

44

Chapter 4-2

Relevance

Evaluate past performance (feedback).

Predicting future performance.

Help assess the risk or uncertainty of achieving future cash flows. (conceptual framework objective)

Income Statement UsefulnessIncome Statement UsefulnessIncome Statement UsefulnessIncome Statement Usefulness

Chapter 4-3

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.

Income Statement LimitationsIncome Statement LimitationsIncome Statement LimitationsIncome Statement Limitations

Chapter 4-4

Income Statement LimitationsIncome Statement LimitationsIncome Statement LimitationsIncome 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 4-5

Elements of the Income StatementElements of the Income StatementElements of the Income StatementElements of the Income Statement

Revenues – Inflows or other enhancements of – Inflows or other enhancements of assets or settlements of its liabilities that assets or settlements of its liabilities that constitute the entity’s ongoing major or central constitute the entity’s ongoing major or central operations.operations.

SalesSales

Fee revenueFee revenue

Interest revenueInterest revenue

Dividend Dividend revenuerevenue

Rent revenueRent revenue

Examples of Revenue Accounts

Chapter 4-6


Expenses – Outflows or other using-up of assets – Outflows or other using-up of assets or incurrences of liabilities that constitute the or incurrences of liabilities that constitute the entity’s ongoing major or central operations.entity’s ongoing major or central operations.

Cost of goods soldCost of goods sold

Depreciation Depreciation expenseexpense

Interest expenseInterest expense

Rent expenseRent expense

Salary expenseSalary expense

Examples of Expense Accounts

Chapter 4-7


Gains – Increases in equity (net assets) from – Increases in equity (net assets) from peripheral or incidental transactions.peripheral or incidental transactions.

Losses - Decreases in equity (net assets) - Decreases in equity (net assets) from peripheral or incidental transactions.from peripheral or incidental transactions.

Gains and losses can result fromGains and losses can result from

sale of investments or plant assets, sale of investments or plant assets,

settlement of liabilities, settlement of liabilities,

write-offs of assets.write-offs of assets.

Chapter 4-8

Single-Step Income StatementSingle-Step Income StatementSingle-Step Income StatementSingle-Step Income Statement

The single-step The single-step statement consists of statement consists of just two groupings:just two groupings:

I ncome Statement (in thousands)

Revenues:

Sales 285,000$

I nterest revenue 17,000

Total revenue 302,000

Expenses:

Cost of goods sold 149,000

Advertising expense 10,000

Depreciation expense 43,000

I nterest expense 21,000

I ncome tax expense 23,700

Total expenses 246,700

Net income 55,300$

Earnings per share 0.75$

RevenuesRevenues

ExpensesExpenses

Net IncomeNet Income

Single- Single- StepStep

Single- Single- StepStep

No distinction between No distinction between OperatingOperating and and Non-Non-operatingoperating categories. categories.

Chapter 4-9

Single-Step Single-Step FormatFormat

Single-Step Single-Step FormatFormat

Administrative expense: Revenues:

Offi cers' salaries 4,900$ Sales 96,500$

Depreciation 3,960 Rental revenue 17,230

Cost of goods sold 63,570 Total revenues 113,730

Rental revenue 17,230 Expenses:

Selling expense: Cost of goods sold 63,570

Transportation- out 2,690 Selling expense 17,150

Sales commissions 7,980 Administrative exense 8,860

Depreciation 6,480 I nterest expense 1,860

Sales 96,500 I ncome tax expense 7,580

I ncome tax expense 7,580 Total expenses 99,020

I nterest expense 1,860 Net income 14,710$

I ncome Statement

For the year ended Dec. 31, 2011

E4-4: Prepare an income statement from the data below.

Chapter 4-10

Multiple-Step Income StatementMultiple-Step Income StatementMultiple-Step Income StatementMultiple-Step Income Statement

The presentation The presentation divides information divides information into major into major sections. sections.

The presentation The presentation divides information divides information into major into major sections. sections.


Sales 285,000$


Gross profi t 136,000

Operating expenses:

Advertising expense 10,000

Depreciation expense 43,000

Total operating expense 53,000

I ncome from operations 83,000

Other revenue (expense):


I nterest expense (21,000)

Total other (4,000)

I ncome before taxes 79,000


Net income 55,300$

Earnings per share 0.75$

1. Operating 1. Operating Section Section

1. Operating 1. Operating Section Section

2. Nonoperating 2. Nonoperating Section Section

2. Nonoperating 2. Nonoperating Section Section

3. Income tax 3. Income tax 3. Income tax 3. Income tax

Chapter 4-11

Multiple-Step Multiple-Step FormatFormat

Multiple-Step Multiple-Step FormatFormat

Administrative expense: Sales 96,500$

Offi cers' salaries 4,900$ Cost of goods sold 63,750

Depreciation 3,960 Gross profit 32,750

Cost of goods sold 63,750 Operating Expenses:

Rental revenue 17,230 Selling expense 17,150

Selling expense: Administrative exense 8,860

Transportation- out 2,690 Total operating expenses 26,010

Sales commissions 7,980 I ncome from operations 6,740

Depreciation 6,480 Other revenue (expense):

Sales 96,500 Rental revenue 17,230

I ncome tax expense 7,580 I nterest expense (1,860)

I nterest expense 1,860 Total other 15,370

I ncome before tax 22,110


Net income 14,530$

I ncome Statement

For the year ended Dec. 31, 2011

Illustration (E4-4): Prepare an income statement from the data below.

Chapter 4-12

Single Step

Used mainly by service firms, banks, utilities

Multiple Step

Used mainly by merchandising and manufacturing firms

Income Statement FormatsIncome Statement FormatsIncome Statement FormatsIncome Statement Formats

Chapter 4-13

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.

Earnings Per ShareEarnings Per ShareEarnings Per ShareEarnings Per Share

Net income - Preferred dividends

Weighted average number of shares outstanding

Basic EPS Calculation

Chapter 4-14

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.

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.

Earnings Per ShareEarnings Per ShareEarnings Per ShareEarnings Per Share

Chapter 4-15

Special Reporting IssuesSpecial Reporting IssuesSpecial Reporting IssuesSpecial Reporting Issues

EPS Info

Present EPS information for

Continuing, Discontinued,

and Extraordinary

Sections.

(Note: Preferred dividends are deducted

from Income from continuing operations)

Chapter 4-16

Reporting Irregular (non-continuing) Reporting Irregular (non-continuing) ItemsItems

Reporting Irregular (non-continuing) Reporting Irregular (non-continuing) ItemsItems

Companies are required to report irregular items Companies are required to report irregular items in the financial statements so users can better in the financial statements so users can better understand the long-run earnings power of the understand the long-run earnings power of the company.company.

Chapter 4-17

Irregular items fall into six categories

Discontinued operations.

Extraordinary items.

Unusual gains and losses.

Changes in accounting principle.

Changes in estimates.

Corrections of errors.

Reporting Irregular ItemsReporting Irregular ItemsReporting Irregular ItemsReporting Irregular Items

Chapter 4-18

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 4-19

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.

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.

Reporting Discontinued OperationsReporting Discontinued OperationsReporting Discontinued OperationsReporting Discontinued Operations

Income from continuing operations

Discontinued operations:

Loss from operations, net of $________ taxLoss on disposal, net of $_________ tax

Net income

Total loss on discontinued operations

Chapter 4-20

Reporting Discontinued OperationsReporting Discontinued OperationsReporting Discontinued OperationsReporting Discontinued Operations




Total other (4,000)



I ncome from continuing operations 55,300


Loss from operations, net of tax 315

Loss on disposal, net of tax 189

Total loss on discontinued operations 504

Net income 54,796$


Sales 285,000$

Cost of goods sold 149,000 Discontinued Discontinued

Operations are Operations are reported after “Income reported after “Income

from continuing from continuing operations.”operations.”

Previously labeled as “Net Income”.

Moved to

Chapter 4-21

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 4-22

Are these items Extraordinary? CA 3

Reporting Extraordinary ItemsReporting Extraordinary ItemsReporting Extraordinary ItemsReporting Extraordinary Items

Chapter 4-23

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.

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 4-24


I nterest revenue 17,000 I nterest expense (21,000) Total other (4,000)

I ncome bef ore taxes 79,000 I ncome tax expense 23,700 I ncome from continuing operations 55,300

Extraordinary loss, net of tax 539

Net income 54,761$


Sales 285,000$

Cost of goods sold 149,000 Extraordinary Items Extraordinary Items

are reported after are reported after “Income from “Income from

continuing continuing operations.”operations.”

Previously labeled as “Net Income”.


Moved to

Chapter 4-25



Total other (4,000)





Loss from operations, net of tax 315

Loss on disposal, net of tax 189


I ncome before extraordinary item 54,796

Extraordinary loss, net of tax 539

Net income 54,257$


Sales 285,000$


Reporting when both Reporting when both

Discontinued Discontinued

Operations and Operations and

Extraordinary Items Extraordinary Items

are present. are present.

Discontinued OperationsDiscontinued Operations

Extraordinary ItemExtraordinary Item

Chapter 4-26

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

Intraperiod Tax AllocationIntraperiod Tax AllocationIntraperiod Tax AllocationIntraperiod Tax Allocation

Chapter 4-27


Total other (4,000)

I ncome f rom cont. oper. before taxes 79,000




Loss on operations, net of $135 tax 315

Loss on disposal, net of $81 tax 189


I ncome before extraordinary item 54,796

Extraordinary loss, net of $231 tax 539

Net income 54,257$


Sales 285,000$


Total Tax Total Tax

AllocatedAllocated

Example of Intraperiod Tax Example of Intraperiod Tax AllocationAllocation

Example of Intraperiod Tax Example of Intraperiod Tax AllocationAllocation

$23,700$23,700

(135)(135)(81)(81)

(231)(231)

$23,253$23,253

Note: losses reduce Note: losses reduce

the total taxthe total tax

Chapter 4-28

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 inventoriesForeign exchange transaction gains and losses

The Board prohibits net-of-tax treatment for these items.


Chapter 4-29

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 4-30

Arcadia HS, purchased equipment for $510,000 Arcadia HS, purchased equipment for $510,000 which was estimated to have a useful life of 10 years which was estimated to have a useful life of 10 years with a salvage value of $10,000 at the end of that with a salvage value of $10,000 at the end of that time. Depreciation has been recorded for 7 years on time. Depreciation has been recorded for 7 years on a straight-line basis. In 2005 (year 8), it is a straight-line basis. In 2005 (year 8), it is determined that the total estimated life should be 15 determined that the total estimated life should be 15 years with a salvage value of $5,000 at the end of years with a salvage value of $5,000 at the end of that time.that time.

Questions:Questions: What is the journal entry to correct What is the journal entry to correct

the prior years’ depreciation?the prior years’ depreciation? Calculate the depreciation expense Calculate the depreciation expense

for 2005.for 2005.

Change in Estimate ExampleChange in Estimate ExampleChange in Estimate ExampleChange in Estimate Example

Chapter 4-31

Change in Estimate ExampleChange in Estimate ExampleChange in Estimate ExampleChange in Estimate ExampleAfter 7 yearsAfter 7 years

Chapter 4-32

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 4-33


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 weighted-average method in 2010, is $30,000.

Illustration 4-10Illustration 4-10Calculation of a Change inAccounting Principle

Illustration 4-11Illustration 4-11Income StatementPresentation of a Changein Accounting Principle (Based on 30% tax rate)

Pretax Income Data

Chapter 4-34

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 4-35

Retained EarningsRetained EarningsRetained EarningsRetained Earnings

IncreaseIncrease

Net incomeNet income

Change in accounting principle

Error corrections

DecreaseDecrease

Net lossNet loss

Dividends

Change in accounting principles

Error corrections

Changes in Retained Earnings

Chapter 4-36

Exercise 4-11 (assume no Exercise 4-11 (assume no comparative financial statements)comparative financial statements)

Exercise 4-11 (assume no Exercise 4-11 (assume no comparative financial statements)comparative financial statements)

Chapter 4-37

All changes in equity during a period except those All changes in equity during a period except those resulting from investments by owners and resulting from investments by owners and distributions to owners.distributions to owners.

Comprehensive IncomeComprehensive IncomeComprehensive IncomeComprehensive Income


Sales 285,000$

Cost of goods sold 149,000 Gross profi t 136,000

Operating expenses:

Advertising expense 10,000 Depreciation expense 43,000

Total operating expense 53,000 I ncome from operations 83,000


I nterest revenue 17,000 I nterest expense (21,000)

Total other (4,000) I ncome bef ore taxes 79,000 I ncome tax expense 24,000 Net income 55,000$

Other Comprehensive Other Comprehensive IncomeIncome

Unrealized gains and losses on available-for-sale securities.

Translation gains and losses on foreign currency.

Plus others

+

Reported in Stockholders’ Equity

Chapter 4-38

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

section in the balance sheetsection in the balance sheet

Other Comprehensive IncomeOther Comprehensive IncomeOther Comprehensive IncomeOther Comprehensive Income

Chapter 4-39

Reporting Comprehensive IncomeReporting Comprehensive IncomeReporting Comprehensive IncomeReporting 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 4-40

Comprehensive IncomeComprehensive IncomeComprehensive IncomeComprehensive Income

Balance Sheet PresentationBalance Sheet Presentation

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

Chapter 4-41

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 4-42

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).

wiley - chapter 4: income statement and related information

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entitys ongoing

year ended

step formatincome

salaries depreciation

partial income

stockholders

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