Intermediate accounting 19th by stice stice chapter 04

Financial Capital Maintenance Concept of Income DeterminationThe financial capital maintenance concept assumes that a company has income “only if the dollar amount of an enterprise’s net

Intermediate

Accounting

James D Stice Earl K Stice

Income Statement

Chapter 4

19 th

Edition

What It Is and What It Isn’t

• Income is not equal to the amount of cash

generated from the successful operation of the business

• Income is a return over and above the

Financial Capital Maintenance Concept of 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

(continued)

Beginning

of Period

End of Period Total assets $510,000 $560,000

Total liabilities 430,000 390,000

Net assets

(owners’ equity) $ 80,000 $170,000

Income is $90,000

Kreidler, Inc had the following assets and

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

(continued)Financial Capital Maintenance

Concept of Income Determination

Net assets, end of period $170,000

Net assets, beginning of period 80,000

Change (increase) in net assets $ 90,000

Deduct investment by owners (40,000)

Add dividends to owners 15,000

If the owners invested $40,000 in the

business and received dividends of $15,000, what would be the income?

Financial Capital Maintenance

Concept of Income Determination

• Income per physical capital maintenance

occurs only if physical production capacity

at the end of the period exceeds the

physical production capacity at the

beginning of the period

• This concept requires that productive

assets be valued at fair market value

• Productive capital is maintained only if the current costs of these capital assets are

maintained

Physical Capital Maintenance

Concept of Income Determination

Practical Difficulties

Practical Difficulties

procedures

information

assets and liabilitiesThe FASB adopted the financial capital maintenance

Physical Capital Maintenance

Concept of Income Determination

Why is a Measure of Income Important?

The recognition, measurement, and

reporting (display) of business income and its components are considered by many to

be the most important tasks of accountants For example:

• Has the activity been profitable?

• What is the trend of profitability?

• Is it increasing profitable, or is there a

downward trend?

(continued)

In the United States, the FASB has

specified that financial accounting

information is designed with investors and creditors in mind, while at the same time

recognizing that many other groups will find the resulting information useful as well.

Accrual-based financial accounting information is not suited for every possible use

Why is a Measure of Income Important?

and Japan, accounting standards have

historically been set by legal processes.

United States and the United Kingdom,

accounting standards are set in response

to market forces.

Why is a Measure of Income Important?

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

• The transaction approach, sometimes referred to as the

matching method, focuses on business events that effect certain elements of the financial statements.

Revenue and Gain Recognition

revenue recognition does not necessarily occur when cash is received.

1 they are realized or realizable, and

2 they have been earned through substantial

completion of the activities involved in the earnings process

(continued)

Revenue and Gain Recognition

company generating the revenue has

provided the bulk of the goods or services it promised for the customer and when the

customer has provided payment or at least

a valid promise of payment to the company.

inventory or other assets must be

exchanged for cash or claims to cash, such

as accounts receivable.

Direct Matching

Direct Matching

• Relating expenses to specific revenues is

often referred to as the matching process

• For example, shipping costs and sales

commissions usually relate directly to

revenues

• Certain expenses have to be estimated to be matched against recognized revenue for the period

(continuedExpense and Loss Recognition

Systematic and Rational Allocation

Systematic and Rational Allocation

The cost of assets that benefit more

than one period, 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

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

Gains and Losses from Changes

in Market Values

• An exception to the transaction approach in the recognition of gains and losses arises

when gains or loss are recognized in the

wake of changes in market value

• When a long-term asset, such as a building, has decreased substantially in value (an

impairment), a loss is recognized even

though the building has not been sold and no transaction has occurred

Form of the Income Statement

• Traditionally, the income from the

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.

(continued

)

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

4. Other revenues and gains

5. Other expenses and losses

6. Income taxes on continuing operations

(continued)

Operations

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)

Determining Subtotals

Determining Subtotals

(continued)Income from Continuing

Operations

Revenue

• Revenue reports the total sales to

customers for the period less any sales

returns and allowances or discounts

• Sales returns and allowances and sales

discounts should be subtracted from gross sales revenue in arriving at net sales

revenue

(continued)Income from Continuing

Operations

Cost of Goods Sold

Cost of Goods Sold

Beginning inventory

+ Net purchases

+ Freight-in

+ Other inventory acquisition costs

= Cost of goods available for sale

– Ending inventory

= Cost of goods sold

(continued)Income from Continuing

Operations

• Cost of goods sold is a significant item on merchandising and manufacturing

companies’ income statements.

inventories rather than one: raw materials, goods in process, and finished goods.

Cost of Goods Sold

Cost of Goods Sold

(continued)Income from Continuing

Operations

• Gross profit percentage is computed by dividing gross profit by revenue from net sales.

measure of profitability that allows

comparisons for a firm from year to year.

Gross Profit

Gross Profit

(continued)Income from Continuing

Operations

 Sales salaries and commissions

 Related payroll taxes

 Advertising and store displays

 Store supplies used

 Depreciation on store furniture

Income from Continuing

Operations

• General and administrative expenses

 Officers’ and office salaries

 Related payroll taxes

 Office supplies used

 Telephone, business licenses, etc.

 Depreciation on office furniture

(continued)Income from Continuing

Operations

Operating income measures the

performance of the fundamental

business operations conducted by a

company.

Operating Income

Operating Income

Gross profit – Operating expenses

= Operating income

Income from Continuing

Operations

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

Other Revenues and Gains

(continued)Income from Continuing

Operations

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

Other Expenses and LossesIncome from Continuing

Operations

• Income tax expense is the sum of all the

income tax consequences of all transactions undertaken by a company during a year

• The separation of income taxes into different sections of the income statement is referred

to as intraperiod income tax allocation.

(continued)Income from Continuing

Operations

Transitory, Irregular, and Extraordinary Items

Transitory, Irregular, and Extraordinary Items

events that are not expected to continue

to impact reported results in future years.

reported in this manner: (1) discontinued operations and (2) extraordinary items.

Income from Continuing

Operations

Discontinued Operations

• The operations and cash flows of the

component must be clearly distinguishable from other operations and cash flows of the company, both physically and operationally,

as well as for financial reporting purposes

• For example, discontinued operations

would result if a company closed one of five product lines in a plant which tracks its cash flows and income separately

To report discontinued operations:

(continued)

• Thom Beard Company has two divisions, A

and B The operations and cash flows of these two divisions are clearly distinguishable, and

so they both qualify as business components

• On June 20, 2013, Thom Beard decides to

dispose of the assets and liabilities of Division

B The revenues and expenses for Thom

Beard for 2013 and for the preceding two

years are shown in Slide 4-58.

Reporting Requirements for Discontinued Operations

Discontinued Operations

• The reporting requirements for

discontinued operations are contained in

FASB ASC Subtopic 205

• On the balance sheet, assets and liabilities associated with discontinued components that have not been completely disposed of

as of the balance sheet date are to be

listed separately in the asset and liability

sections of the balance sheet

(continued)

International Accounting for

Discontinued Operations

According to IFRS 5, companies with

discontinued operations must disclose the

following:

• The amount of revenue, expenses, and

pretax profit or loss attributed to the

discontinued operations and related income tax expense

• A separate disclosure of the assets, liabilities, and cash flows of the discontinued

operations

Extraordinary Items

Extraordinary items are events and

transactions that are both unusual in nature

and infrequent in occurrence Thus, they

must contain “a high 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 reasonably be expected

to recur in the foreseeable future .”¹

¹Opinions of the Accounting Principles Board No 30, “Reporting the

Results of Operations (NY: AICPA, 1973), par 20.

(continued)

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

a change from one accounting principle

to another.

accounting principle because a change

in economic conditions suggests that an accounting change will provide better

information.

(continued)

• More frequently, a change in accounting principle occurs because the FASB

issues a new pronouncement requiring a change in principle.

statements for all years presented must

be restated using the new accounting

method.

Changes in Accounting

Principles

Changes in Estimate

• In reporting periodic revenues and in attempting

to properly match those expenses incurred to generate current-period revenues, accountants must continually make judgments

• Estimates are required for such factors as the number of years of useful life for depreciable

assets, the amount of uncollectible accounts

expected, and the amount of warrant liability to

be recorded on the books

• No retroactive adjustments

(continued)

Net Income or Loss

Income or loss from continuing

operations combined with the results of discontinued operations and

extraordinary items provides a

summary measure of the firm’s

performance for a period: net income

or net loss.

Earnings per share =

Income from continuing operations

Weighted average number of shares of

common stock outstanding

(continued)Earnings Per Share

• Earnings per share amounts are computed for income from

continuing operations and for each unusual or extraordinary item.

• If necessary, companies display basic and diluted earnings per

The price-earnings (P/E) ratio

expresses the 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 =

(continued)Price-Earnings (P/E) Ratio

In general, the following types of firms

possibilities

average because of a nonrecurring event

Price-Earnings (P/E) Ratio

Price-Earnings (P/E) Ratio

In general, the following types of firms

than average because of a nonrecurring

event

Comprehensive Income

• Comprehensive income is the number used to reflect an overall measure of the change in a

company’s wealth during the period

• In addition to net income, 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

Forecasting Future Performance

used to predict the future.

factors that determine a certain level of

revenue or expense.

to grow and represents the general volume of activity expected in the company.

(continued)

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