Intermediate accounting 17e stice skousen cengage chapter 04

Income Determination The financial capital maintenance concept assumes that a company has income “only if the dollar amount of an enterprise’s net assets at the end of the period exce

The Income Statement

Intermediate Accounting,17E

Stice | Stice | Skousen

Income Determination

The financial capital maintenance

concept assumes that a company has

income “only if the dollar amount of an

enterprise’s net assets at the end of the

period exceeds the dollar amount of net

assets at the beginning of the period after

excluding the effects of transactions with

owners.

Beginning

of Period

End of Period

Financial Capital Maintenance

Kreidler, Inc had the following assets and

liabilities at the beginning and at the end of a period.

Financial Capital Maintenance

If the owners invested $40,000 in the business and received dividends of $15,000, what

would be the income?

Physical Capital Maintenance

exceeds capacity at the beginning of the period.

and net realizable value.

considered a capital maintenance adjustment and not part

of income.

• Has the activity been profitable?

• What is the trend of profitability?

• Is it increasing profitable, or is there a

downward trend?

Transaction Approach

To provide detail concerning the

components of income, accountants have

adopted a transaction approach to

measuring income that stresses the direct

computation of revenues and expenses.

4-8

Revenue and Gain Recognition

• Revenue is recognized when goods or services

have been provided and the customer commits

to payment.

• Revenues and gains are recognized when:

1 They are realized or realizable, and

2 They have been earned through substantial

completion of the activities involved in the earnings process

1 If a market exists for a product so that its sale at an

established price is practically ensured without

significant selling effort, revenue may be recognized

at the point of completed production.

(continues)

Earlier Recognition

Earlier Recognition (concl.)

2 If a product or service is contracted for in advance,

revenue may be recognized as production takes

place or as services are performed, especially if the production or performance period extends over

more than one fiscal year

Later Recognition

• If payment for products or services is

considered doubtful, revenues and gains

may be recognized as the cash is

received.

• Installment sales method

• Cost recovery method

Expense and Loss Recognition

Systematic and Rational Allocation

The cost of assets such as buildings, equipment, patents, and prepaid insurance are spread across the periods of expected benefit

in some systematic and rational way

Expense and Loss Recognition

Immediate Recognition

• Many expenses are not related to specific

revenues but are incurred to obtain goods and services that indirectly help to generate

revenues

• Examples include office salaries, utilities, and

general advertising These are recognized as expenses in the period in which they are

incurred

Expense and Loss Recognition

Form of the Income Statement

Traditionally, the income from continuing operations category has been presented in

multiple-step form Using this format, the income statement is divided into separate

sections, and various subtotals reflect

different levels of profitability.

(continues)

(continued)

(concluded)

Techtronics Corporation

For discussion purposes, the multiple-step income statement for Techtronics Corporation will be

used This statement is shown in

Slides 4-21 and 4-22

4-22

Form of the Income Statement

• Comparative financial statements present

several years’ financial statements side by side

This enables users to analyze performance over

multiple periods and identify significant trends

• Consolidated financial statements combine the

financial results of the “parent company” with

other companies that it owns, called subsidiaries

Gross profit =

Revenue – Cost of goods sold

Operating income =

Gross profit – Operating expenses

Income from Continuing Operations

Determining Subtotals

Income from continuing operations before taxes = Operating income + Other revenues and gains – Other expenses and losses

Income from continuing operations = Income

from continuing operations before income taxes – Income taxes on continuing operations

Income from Continuing Operations

Determining Subtotals

Revenue reports the total sales to customers for the period less any sales returns and allowances or discounts.

Components of the Income

Statement

Cost of Goods Sold

Components of the Income

Statement

Beginning inventory + Net purchases

+ Freight-in

+ Other inventory acquisition costs

= Cost of goods available for sale

– Ending inventory

= Cost of goods sold

Cost of goods sold is a significant item on merchandising and

manufacturing companies’

income statements.

Components of the Income

Statement

Operating expenses may be reported

Operating income measures the

performance of the fundamental business

operations conducted by a company.

Operating Income

Components of the Income

Statement

Gross profit – Operating expenses

= Operating income

This section usually includes items

identified with the peripheral activities of

the company.

• Rent revenue

• Interest revenue

• Dividend revenue

• Gains from the sale of assets

Other Revenues and Gains

Components of the Income

Statement

This section parallels “Other Revenues

and Gains” except the items result in

deductions from operating income.

• Interest expense

• Losses from the sale of assets

Other Expenses and Losses

Components of the Income

Statement

Discontinued Operations

• The operations and cash flows of the component

must be clearly identifiable

• For example, discontinued operations would result

if a company closed one of four operating segments which tracks its cash flows and income separately

• The ultimate disposal must be expected within one

year of the period for which results are being

To report discontinued operations:

• The component may be unprofitable.

• The component may not fit into the long-range plans

for the company

• Management may need funds to reduce long-term

debt or to expand into other areas

• Management may be fearful of a corporate takeover

by new investors desiring to gain control of the

company

Why Discontinue?

separately in the asset and liability sections of the balance sheet.

In addition to the summary income or loss amount reported in the income statement, the total

revenue associated with the discontinued operations should be disclosed in the financial

statement notes.

Discontinued Operations

Extraordinary Items

Extraordinary items are events and transactions

that are both unusual in nature and infrequent in

degree of abnormality and be of a type clearly

unrelated to, or only incidentally related to, the

ordinary and typical activities of the entity

[and] be of a type that would not reasonable be

expected to recur in the foreseeable future .”¹

Not Extraordinary

• The write-down or write-off of receivables,

inventories, equipment leased to others, etc

• The gains or losses from exchange or remeasurement

of foreign currencies

• The gains or losses on disposal of business segment

• Other gains or losses from sale or abandonment of

productive assets

• The effects of a strike

• Adjustment of accruals on long-term contracts

Changes in Accounting

Principles

Criteria for change:

that an accounting change will provide better information.

requiring a change in principle.

Changes in Accounting

Principles

• When there is a change in accounting principle or

method, a company is required to determine how

the income statement would have been different in past years if the new accounting method had been used all along.

• Income statements for all years presented must be

restated using the new accounting method

(continues)

Changes in Accounting

Principles

• The beginning balance of Retained Earnings for the

oldest period presented should reflect an

adjustment for the cumulative income effect of the accounting change on the net income of all

preceding years for which a detailed income

statement is not presented

• Include information as if the change were

retroactive—direct and indirect effects

Disclosure requirements include:

• Employ current and prospective approach.

• Report current and future financial statements on new

basis

• Present prior periods as previously reported.

• Make no adjustments to current period opening

balances

• Present no data.

Change in Estimate

If there is both a change in principle and a change in estimate for an item, the event is treated as

Change in Estimate

Effects of Changing Prices

Accountants have traditionally ignored the effects of changing prices, especially when gains would result from recognition

McDonald’s used the following approach in its 10-K filed with the SEC

Earnings Per Share

• Earnings per share amounts are

computed for income from continuing

operations

• Earnings per share amounts are

calculated for each irregular or

extraordinary item.

When presenting earnings-per-share figures:

Earnings per share =

Income from continuing operations Weighted average number of shares of

common stock outstanding

Earnings Per Share

Price-Earnings (P/E) Ratio

market value of common stock as a multiple of

earnings and allows investors to evaluate the

attractiveness of a firm’s common stock.

Market value per share Earnings per share P/E ratio =

Comprehensive Income

• Comprehensive income is the number used to reflect

an overall measure of the change in a company’s

wealth during the period

• It includes items that arise from changes in market

conditions unrelated to the business operations of a company

• Most companies include a report of comprehensive

income as part of the statement of stockholders’

equity

Comprehensive Income

The more common adjustments made in arriving

at comprehensive income are:

• Foreign currency translation adjustments

• Unrealized gains and losses on

available-for-sale securities

• Deferred gains and losses on derivative

financial instruments

Forecasting Future Performance

• Financial statements report the past, but are

used to predict the future.

• Key to a good forecast involves identifying

factors that determine a certain level of

revenue or expense.

• Forecasting starts with a forecast for sales

• Most expense forecasts are driven from sales

forecasts.