The Income Statement and Statement of Cash Flows4Copyright © 2007 by The McGraw-Hill Companies, docx

4-3 Comprehensive Income An expanded version of income that includes four types of gains and losses that traditionally have not been included in income statements... W hen a derivative

Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved

The Income Statement and Statement of Cash Flows

4

4-2

Learning Objectives

Explain the difference between net income and

comprehensive income and how we report

components of the difference.

4-3

Comprehensive Income

An expanded version of income that includes four types of gains and losses that traditionally have not been included

in income statements.

Other Comprehensive Income

Statement of Financial Accounting Standards No 130

Comprehensive income includes traditional net income

and changes in equity from nonowner transactions.

1 Changes in the market value of securities available for sale

(described in Chapter 12)

2 Gains, losses, and amendment costs for pensions and other

postretirement plans (described in Chapter 17)

3 W hen a derivative is designated as 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 (described in

Chapter 14)

4 Gains or losses from changes in foreign currency exchange rates

(discussed elsewhere in your accounting curriculum)

4-5

Accumulated Other Comprehensive Income

In addition to reporting comprehensive income that

occurs in the current period, we must also report these

amounts on a cumulative basis in the balance sheet as

an additional component of shareholders’ equity.

(In millions, except shares) 2004 2003

Common Stockholde rs' Investment:

Common stock, $.10 par value , 800 million

shares authorized, 300 m illion shares

issued for 2004 and 299 million shares $ 30 $ 30

issued for 2003

Additional pa id-in capital 1,079 1,088

Retained earnings 7,001 6,250

Accumula ted other comprehensive loss (46) (30)

8,064 7,338 Less deferred compensation and treasury

stock at cost 28 50

Total common stockholders' investme nt $ 8,036 $ 7,288

FedEx Corporation Balance Sheet 31-Ma y

4-6

Learning Objectives

Discuss the importance of income from

continuing operations and describe its

components.

Outflows of

resources

incurred in

generating

revenues.

Revenues

Inflows of

resources

resulting

from

providing

goods or

services to

customers.

Gains and Losses Increases or decreases in equity from peripheral or incidental transactions

of an entity.

Income from Continuing Operations

Income Tax Expense Because of its importance and size, income tax expense is a separate item

4-8

Operating

Income

Nonoperating Income

Operating Income Versus Nonoperating

Income

Includes revenues

and expenses

directly related to

the principal

revenue-generating

activities of the

company

Includes gains and losses and revenues and expenses related

to peripheral or incidental activities of the company

4-9

Income Statement (Single-Step)

Expenses

& Losses {

MAXWELL GEAR COMPANY Income Statement For the Year Ended December 31, 2006

Revenues a nd gains:

Sales $ 573,522 Interest and dividends 26,400

Ga in on sale of opearting assets 5,500 Total revenue s a nd gains 605,422 Expenses and losses:

Cost of goods sold $ 302,371 Selling 47,341

Ge neral and administrative 24,888 Research and development 16,300 Interest 6,200 Loss on sale of investment 8,322 Income taxes 80,000 Total expenses & losses 485,422

{

Revenues

& Gains

{

Proper Heading

Income Statement (Multiple-Step)

{

Non-operating

Items

MAXWELL GEAR CORPORATION Income Statement For the Year Ended December 31, 2006 Sales revenue $ 573,522 Cost of goods sold 302,371 Gross profit 271,151 Opera ting expenses:

Selling $ 47,341 General and administra tive 24,888 Research a nd development 16,300 88,529 Opera ting income 182,622 Other income (expense):

Interest a nd dividend revenue $ 26,400 Gain on sale of operating assets 5,500 Interest e xpense (6,200) Loss on sale of investments (8,322) 17,378 Income before income taxes 200,000 Income tax e xpense 80,000 Net income $ 120,000

{

Gross

Profit

{

Proper Heading

Operating

Expenses {

4-11

Learning Objectives

Describe earnings quality and how it is impacted by management practices to manipulate earnings.

4-12

Earnings Quality

Earnings quality refers to

the ability of reported

earnings to predict a

company’s future.

The relevance of any

historical-based financial

statement hinges on its

predictive value

Manipulating Income and Income Smoothing

“Most managers prefer to report earnings that follow a

smooth, regular, upward path.”1

Two ways to manipulate income:

1 Income shifting

2 Income statement classification

1Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p 168.

4-14

Learning Objectives

Discuss the components of operating and

nonoperating income and their relationship to

earnings quality.

4-15

Operating Income and Earnings Quality

Should all items of revenue and expense included in

operating income be considered indicative of a

company’s permanent earnings?

No, not necessarily.

Operating expenses may include the following unusual items

that may or may not continue in the future:

•Restructuring costs

•Goodwill impairment

•Long-lived asset impairment

•In-process research and development

Operating Income and Earnings Quality

Restructuring Costs

Costs associated with shutdown or relocation of facilities or downsizing of operations are recognized in the period incurred.

Goodwill Impairment

and Long-lived Asset

Impairment

Involves asset impairment losses

or charges (discussed further in Chapters 10 & 11).

In-process Research

and Development

Results from certain business combinations (discussed further in Chapter 10).

4-17

Nonoperating Income and Earnings Quality

Gains and losses from the sale of operational

assets and investments often can significantly

inflate or deflate current earnings.

Example

As the stock market boom reached its

height late in the year 2000, many

companies recorded large gains from

sale of investments that had

appreciated significantly in value

How should those gains be interpreted in terms of their relationship to future earnings? Are they transitory

or permanent?

4-18

Pro Forma Earnings

Companies often voluntarily provide a pro forma

earnings number when they announce annual or

quarterly earnings Pro forma earnings are

management’s assessment of permanent earnings.

The Sarbanes-Oxley Act Section 401 requires a reconciliation between pro forma earnings and earnings determined according to GAAP.

Separately Reported Items

Reported separately, net of taxes:

Discontinued

operations

$ xx x

x x

xx x

x x

x x

Extra ordina ry items (net of $xx in

taxe s)

Income from continuing operations

before income taxe s and

e xtra ordina ry items

Income tax expense

Income from continuing operations

before extraordina ry items

Discontinued ope rations (net of $x x

in taxe s)

Extraordinary items

A third item, the cumulative effect of

a change in accounting

eliminated from separate reporting

by a new accounting standard in 2005

4-20

Intraperiod Income Tax Allocation

Income Tax Expense must be associated with

each component of income that causes it.

Show Income Tax

Expense related to

Income from

Continuing

Operations.

Report effects of Discontinued Operations and Extraordinary Items

NET OF RELATED INCOME TAXES

4-21

Learning Objectives

Define what constitutes discontinued

operations and describe the appropriate

income statement presentation for these

transactions.

p A discontinued operation is the sale or

disposal of a component of an entity

p A component comprises operations and

cash flows that can be clearly

distinguished, operationally and for

financial reporting purposes, from the rest

of the entity

p A component could include:

p Reportable segments

p Operating segments

p Reporting units

p Subsidiaries

p Asset groups

Discontinued Operations

4-23

Discontinued Operations

Report results of operations separately if two

conditions are met:

The operations and

cash flows of the

component have been

(or will be) eliminated

from the ongoing

operations

The entity will not have any significant continuing involvement

in the operations of the component after the disposal transaction

4-24

Discontinued Operations

Reporting for Components Sold

Operating income or

loss of the component

from the beginning of

the reporting period to

the disposal date

Gain or loss on the disposal of the component

Reporting for Components Held For Sale

Operating income or

loss of the component

from the beginning of

the reporting period to

the end of the reporting

An “impairment loss” if the carrying value of the assets of the component is more than the fair value

During the year, Apex Co sold an

unprofitable component of the company The

component had a net loss from operations

during the period of $150,000 and its assets

sold at a loss of $100,000 Apex reported

income from continuing operations of

$128,387 All items are taxed at 30%

How will this appear in the income

statement?

Discontinued Operations Example

4-26

Loss from discontinued operations $ (150,000)

Less: Tax benefit ($150,000 × 30%) 45,000

Net loss $ (105,000)

Loss on disposal of assets $ (100,000)

Less: Tax benefit ($100,000 × 30%) 30,000

Net loss $ (70,000)

Discontinued Operations Example

Computation of Loss from Discontinued Operations

(Net of Tax Effect):

4-27

Income from continuing operations $ 128,387

Discontinued ope rations:

Loss from operations of discontinued

component (net of ta x be nefit of

$45,000) (105,000)

Loss on disposal of discontinued

component (net of ta x be nefit of

$30,000) (70,000)

Net loss $ (46,613)

Income Statement Presentation:

Discontinued Operations Example

Learning Objectives

Define extraordinary items and describe the

appropriate income statement presentation for

these transactions.

4-29

transactions

p Unusual in nature

p Infrequent in occurrence

taxes

Extraordinary Items

4-30

During the year, Apex Co experienced a

loss of $75,000 due to an earthquake at one

of its manufacturing plants in Nashville

This was considered an extraordinary item

The company reported income before

extraordinary item of $128,387 All gains

and losses are subject to a 30% tax rate.

How would this item appear in the

income statement?

Extraordinary Items Example

Extra ordina ry Loss $ (75,000)

Less: Tax Benefits

($75,000 × 30%) 22,500

Income before extraordinary item $ 128,387

Extraordinary Loss:

Earthquake loss

(net of tax benefit of $22,500) (52,500)

Income Statement Presentation:

Extraordinary Items Example

Computation of Loss from Extraordinary Item (Net of

Tax Effect):

4-32

Unusual or Infrequent Items

Items that are material and are either

unusual or infrequent— but not both —

are included as a separate item in

continuing operations.

4-33

Type of Accounting

Change in Accounting

Principle

Change from one GAAP method

to another GAAP method

Change in Accounting

Estimate

Revision of an estimate because of new information or new experience

Change in Reporting

Entity

Preparation of financial statements for an accounting entity other than the entity that existed in the previous period

Accounting Changes

Learning Objectives

Describe the measurement and reporting

requirements for a change in accounting

principle.

4-35

Change in Accounting Principle

pOccurs when changing from one GAAP

method to another GAAP method

nFor example, a change from LIFO to FIFO

pVoluntary changes in accounting

principles are accounted for

retrospectively by revising prior years’

financial statements.

pChanges in depreciation, amortization, or

depletion methods are accounted for the

same way as a change in accounting

estimate.

4-36

Learning Objectives

Explain the accounting treatments of changes

in estimates and correction of errors.

Change in Accounting Estimate

Revision of a

previous accounting

estimate

Use new estimate in

current and future

periods

Includes treatment for

changes in depreciation,

amortization, and

depletion methods

4-38

Change in Accounting Estimate Example

On January 1, 2003, we purchased

equipment costing $30,000, with a useful

life of 10 years and no salvage value

During 2006 , we determine that the

remaining useful is 5 years (8-year total

life) We use straight-line depreciation.

Compute the revised depreciation

expense for 2006.

4-39

Asset cost $ 30,000

Accumulated depre ciation

12/31/05 - ($3,000 × 3 years) (9,000)

Re maining to be deprecia ted 21,000

Re maining useful life ÷ 5 ye ars

Re vised annual depreciation $ 4,200

Record depreciation expense of $4,200 for

2006 and subsequent years.

Change in Accounting Estimate Example

Date Description PR Debit Credit

4,200 Accumulated Depreciation 4,200

Depreciation Expense

Change in Reporting Entity

If two entities combine, a single

financial statements is generally required.

4-41

Change in Reporting Entity

A change in reporting entity is reported by restating all previous periods’ financial statements presented for comparative purposes as if the new reporting entity existed

in those periods.

4-42

previous period

adjustment to beginning

retained earnings

net of income taxes

Prior Period Adjustments

Prior Period Adjustments Example

While reviewing the depreciation entries for

2002-2007, the controller found that in 2006

depreciation expense was incorrectly debited

for $150,000 when in fact it should have been

debited $125,000 (Ignore income taxes.)

Prepare the necessary journal entry in 2007 to

correct this prior period error.

12/31/06 Depreciation Expense 150,000

Accumulated Depreciation 150,000

4-44

Accumulated Depreciation 25,000

Retained Earnings 25,000

2007 Entry

Prior Period Adjustments Example

4-45

Learning Objectives

Define earnings per share (EPS) and explain

required disclosures of EPS for certain income

statement components.

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

Net income less preferred dividends

Weighted-average number of

common shares outstanding for the

period

Diluted EPS

Reflects the potential dilution that could occur for companies that have certain securities outstanding that are convertible into common shares or stock options that could create additional common shares if the options were exercised

4-47

Earnings Per Share Disclosure

Report EPS data separately for:

1 Income from Continuing Operations

2 Separately Reported Items

a) Discontinued Operations

b) Extraordinary Items

3 Net Income

4-48

Learning Objectives

Describe the purpose of the statement of cash

flows.