Financial accounting 9th jamie pratt chapter 13

 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  There are different inc

Chapter 13:

The Complete Income Statement

 2

The Economic Consequences Associated with Income Measurement and Disclosure

 Income is the most common measure of a company’s performance.

 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

 There are different income measures which relate to different objectives (GAAP provides for various measures to be presented)

 3

The Measurement of Income: Different Measures for Different Objectives

 4

 According to Statement of Financial Accounting

Concepts No 1 Objectives of financial reporting

are (paraphrased) to provide information that is:

 Useful to those making investment and credit

The Measurement of Income: Different Measures for Different Objectives (cont’d)

 5

Figure 13-1 (partial) Elements of the financial statements

The Measurement of Income: Different Measures for Different Objectives (cont’d)

 6

Figure 13-1 (partial) Elements of the financial statements

The Measurement of Income: Different Measures for Different Objectives (cont’d)

 7

Figure 13-1 (partial) Elements of the financial statements

The Measurement of Income: Different Measures for Different Objectives (cont’d)

 Comprehensive income - changes in net assets from all

non-owner sources; is broken into two categories:

 Net Income: consisting of revenues, expenses, gains and

losses (next slide)

 Other Comprehensive Income

 8

Campbell’s Soup 2012 statement of Shareholders’ Equity

 9

Operating Section Sales Revenue

Net Income 5

Earnings per Share 6

The Income Statement

Two Different Concepts of Income:

Matching and Fair Market Value

 Revenues - Expenses = Net Income

 FMV Net Assets (end) - FMV Net Assets (beginning) = Net Income

 10

Financing, Investing, and Operating Transactions: A Framework

 11

Figure 13-2 Classifying financing, investing, and operating transactions

Classifying Operating Transactions

 12

Figure 13-3 Classifying operating transactions

A Complete Income Statement: Disclosure and Presentation

 See Figure 13-4 for sample format:

- Other expenses and losses

= Income from continuing operations (IFCO) +/- Discontinued operations

+/- Extraordinary items

= Net income Earnings per Share

 13

 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.

 14

(1) Operating Revenues and Expenses: Usual and Frequent

Looking at Figure 13-4 A Complete Income Statement

Asset and liability inflows and outflows related

to the delivery of goods or services provided by

a company and Operating Revenues and Expenses

They are usual and frequent and therefore are likely to represent ongoing activity

 15

(2) Other Revenues and Expenses: Unusual or Infrequent

 Related to secondary or auxiliary activities:

 16

 Interest Income – from financing

 Interest Expense – from financing

 Dividend Income

 Gains and Losses from trading securities

 Gains and Losses from sale of investments and long-lived assets

 Long-term asset or goodwill impairments

 Receivable inventory write-downs

 Gains and Losses from foreign currency transactions

 Employee strikes

 Rental income

 Gains and Losses from litigation

 Some of these are recurring, but none are core

activities

(3) Disposal of a Business Segment

 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.

 17

(4) Extraordinary Items: Unusual and Infrequent

 Extraordinary items (EI) are defined as those

activities that are material in amount, unusual in nature, and infrequent in occurrence.

 To determine, consider the natural, political, and economic environment of the firm (i.e the same type of event may be extraordinary for some and may not be extraordinary for other organizations).

 Examples of EI include natural disasters, nationalization or expropriation of assets by a foreign government, and one-time major economic transactions.

 18

(5) Mandatory Changes in Accounting Principles

 Consistency requires the use of the same accounting method from year to year.

 However, a company may on occasion choose to change to an alternative accounting method (ex: depreciation method or FIFO to average cost for inventory).

 A company may be required to change to a new accounting technique by the issue of a new accounting standard.

 Changes may require retrospective application or involve adjustments

to retained earnings They may require disclosure on the income statement

 For mandatory changes the method is dictated in the new standard

 For discretionary changes, retroactive treatment with disclosure is required.

 19

 20

(5) Mandatory Changes (cont’d)

Figure 13-5 Starbucks excerpts from the annual report

Intraperiod Tax Allocation

 Accounting standards require certain items to be presented

on the income statement net of taxes to better determine and isolate the true impact of the events

 Disposal of a business segment

 Extraordinary items

 Changes in Accounting principles

 All of these items are presented net of tax on the income

statement

 21

Earnings-Per-Share Disclosure (EPS)

 SFAS 128 simplified the presentation of earnings per share to two components:

 Basic EPS

 Diluted EPS

 Calculation of Basic EPS =

_ Net Income - preferred dividends

Weighted average common shares outstanding

 Concept: To indicate how much each common shareholder “owns” with respect

to earnings.

 Preferred dividends are deducted - if declared or if cumulative - because they are

“owed” to preferred shareholders.

 This is a calculation of “what is” - the numerator and denominator use actual

shares outstanding and actual net income for the year.

 22

Earnings-Per-Share (EPS) (cont’d)

*Note that the convertibility component is ignored for basic EPS

 23

Earnings-Per-Share (EPS) (cont’d)

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

 24

EPS Disclosure

 Separate EPS disclosure for:

 Net income from continuing operations (after tax)

 Disposals of business segments

Problems with EPS

earning management techniques.

buybacks (treasury stock).

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

 26

Income Statement Categories:

Useful For Decisions but Subjective

 Earning persistence is the concept that some earnings dollar are likely to continue in the future, but others are not Those that due provide future cash flow and are valued higher by external users of

financial statements

 Categorizing may be used subjectively by companies to ‘manage earnings’ and public perception of the financial outcomes.

 27

Economic Consequences of Reporting Net Income – After the Chapter

 Investors focus heavily on income and related indices like earnings per share and the P/E (price per share to

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

 28

Copyright © 2014 John Wiley & Sons, Inc All rights reserved Reproduction

or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

 29