Financial accounting in an economic context 8e chapter 013

Format of the Income StatementSee Page 606 for sample format: Sales - COGS = Gross profit - Operating expenses = Income from operations + Other revenues and gains - Other expenses and l

Chapter 13:

Income Statement

What is Income (Profit)?

 A measure of a change in value

– As compared to equity, which measures the level of value (or wealth)

 It is NOT net cash flow

 It is a measure of performance

 It is a link between two balance

sheets

Figure 13-1

Figure 13-1

5

Figure 13-1

Elements of the Income Statement

from all non-owner sources; is broken into two

categories:

gains and losses (next slide)

Campbell’s Soup 2009 statement of Shareholders’ Equity

The Income Statement

Operating

Section

Sales Revenue less: Cost of Goods Sold less: Selling Expenses less: Administrative Expenses

Two Different Concepts of Income:

Matching and Fair Market Value

The matching process:

Revenues - Expenses = Net Income

Fair Market Value approach:

FMV Net Assets (end) - FMV Net Assets

(beginning) = Net Income

9

Financing, Investing, and Operating

Transactions: A Framework

Classifying Operating Transactions

11

Format of the Income Statement

See Page 606 for sample format:

Sales

- COGS

= Gross profit

- Operating expenses

= Income from operations

+ Other revenues and gains

- Other expenses and losses

= Income from continuing operations (IFCO)

Format of the Income Statement

 First, note the subtotals

– Gross profit is presented when a company uses

a multi-step income statement; more relevant for companies that are primarily retail or

manufacturing (less relevant for service

industries).

– Income from operations indicates income from

primary, on-going activity (usual and frequent).

– Income from continuing operations (IFCO)

also includes peripheral activity like interest

income, as well as potentially nonrecurring

activity like restructuring charges (unusual or

infrequent).

– Net income also includes “special” items that are

presented separately because they are

significant activities that are usually nonrecurring.

Format of the Income Statement

 Now, more information on the “special” items below Income From Continuing Operations (IFCO):

– discontinued operations

– extraordinary items

 Note that each of these items is presented “net of tax.” This is necessary because income tax

expense has already been calculated on IFCO

Therefore, each level below IFCO must present the tax effect for that component

 This is called “intraperiod” tax allocation -

allocation of income tax expense to different parts

of the income statement

Format - Discontinued Operations

 Discontinued operations (DO) relate to the disposal of

a segment of a company Because the disposal

means that the segment activity will be discontinued, separate disclosures are required so that investors

could distinguish between ongoing activity and

nonrecurring activity.

 A segment is defined as an entire line of business or a separately identifiable segment For example, General Motors would need to discontinue Chevrolet (not just a manufacturing plant).

 Financial statement presentation includes any

operating income or loss to the measurement date (the date the board of directors declares intention to

dispose of the segment), as well as any gain or loss on the disposal of the assets.

Format - Extraordinary Items

 Extraordinary items (EI) are defined as those activities that

are material in amount, unusual in nature, and infrequent in

 If unusual or infrequent, but not both, report in “other

gains/losses”, as part of IFCO Examples include material

write-down of receivables, and losses from an employee strike.

Income Statement Format - Other Issues

 Consistency requires the use of the same accounting

method from year to year.

 However, a company may choose to change to an

alternative accounting method (ex: DDB to SL or FIFO

to average).

 Also, a company may be required to change to a new accounting technique by the issue of a new accounting standard.

 Accounting standards required companies to show the

cumulative effect for prior years’ income on the

current income statement in a special category called

“change in accounting principle.”

Income Statement Format - Other Issues

 This special category allowed investors to

analyze IFCO for the current year separately

from the effect of the cumulative change

reported as part of current net income, even

though it relates to prior years’ net income

category from the income statement Now all

changes in principle receive either a retroactive restatement (like errors of a prior period) or a

prospective treatment (like changes in estimate)

Figure 13-5

19

Earnings Per Share (EPS)

components:

Net Income - preferred dividends

Weighted average common shares outstanding

respect to earnings.

because they are “owed” to preferred shareholders.

actual shares outstanding and actual net income for the year.

Earnings Per Share (EPS)

Class problem:

Bush Company reported net income of $30,000 in

2007 The company had 60,000 shares of common stock outstanding for all of 2007 Bush also had

5,000 shares of convertible preferred stock

outstanding for all of 2007 During 2007, the

company declared a $4,000 cash dividend to

preferred shareholders Each share of preferred

stock is convertible to 4 shares of common stock

1.Calculate basic EPS:

$30,000 - 4,000 = $0.43 per share 60,000

(Note that the convertibility component is ignored for

basic EPS.)

Earnings Per Share (EPS)

2 Calculate diluted EPS:

$30,000 - 0 _ = $0.38 per share

60,000 + (5,000 x 4)

Note that the convertibility component is assumed to have been exercised for diluted EPS If the PS

was converted to CS at the beginning of the year,

there would have been NO preferred dividend,

and there would have been 20,000 additional

shares of common stock outstanding all year

The effects for convertible bonds and employee

stock options are similar for diluted EPS

EPS Disclosure

 Separate EPS disclosure for:

– Net income from continuing operations (after

tax)

– Disposals of business segments

– Extraordinary items

 Calculation

– Separate dollar amount (from above

categories) divided by number of common

shares outstanding

 If diluted EPS exists, the company should also

calculate diluted EPS for each level of

presentation

 If diluted EPS is antidilutive (the calculation is

actually higher than basic EPS), the company

does not have to present diluted EPS

Problems with EPS

 The numerator can be manipulated by a number of

earning management techniques.

 The denominator can be manipulated by stock buybacks (treasury stock).

 The “what-if” presentation of diluted EPS is a fictitious

number - it can never actually happen The potentially

dilutive securities have not been converted at year end,

and they can never have claims to the current year’s

income The only benefit of diluted EPS is that it can

indicate the magnitude of the maximum potential dilution for the future

earnings per share) ratio.

 Recent announcements (noting that the reported EPS was off the estimate by as little as a penny) have caused the market price of reporting companies to drop significantly.

 Because of investor focus, and because of compensation bonuses, managers continue to focus heavily on the

bottom line, sometimes with dire effects.

 Expanded financial statement disclosure and increased awareness by investors may drive this earnings fixation

International Perspective

 Under IFRS an entity must present a

statement of comprehensive income, often called the statement of recognize income

and expenses (SORIE) The SORIE

below was taken from the 2008 annual

report of Unilever Group.

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