Intructor manual intermediate accounting 15th kiesoch04

Chapter 4 presents a detailed discussion of the concepts and techniques that underlie thepreparation of the income statement and retained earnings statement and the reporting ofother com

CHAPTER 4 Income Statement and Related Information

ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)

Brief

Concepts for Analysis

ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)

Learning Objectives

Brief

1 Understand the uses and limitations

6 Understand the reporting of accounting

changes and errors

ASSIGNMENT CHARACTERISTICS TABLE

Time (minut es)

E4-1 Computation of net income Simple 18–20 E4-2 Compute income measures Simple 15-20

E4-3 Income statement items Simple 15–20

E4-4 Single-step income statement Moderate 20–25

E4-5 Multiple-step and single-step Simple 30–35

E4-6 Multiple-step and extraordinary items Moderate 30–35

E4-7 Multiple-step and single-step Moderate 30–40

E4-8 Income statement, EPS Simple 15–20

E4-9 Multiple-step statement with retained earnings Simple 30–35

E4-10 Earnings per share Simple 20–25

E4-11 Condensed income statement—periodic inventory

method.

Moderate 20–25

E4-12 Retained earnings statement Simple 20–25

E4-13 Earnings per share Moderate 15–20

E4-14 Change in accounting principle Moderate 15–20

E4-15 Comprehensive income Simple 15–20

E4-16 Comprehensive income Moderate 15–20 E4-17 Various reporting formats Moderate 30–35

P4-1 Multiple-step income, retained earnings Moderate 30–35

P4-2 Single-step income, retained earnings, periodic inventory Simple 25–30

P4-4 Multiple- and single-step income, retained earnings Moderate 45–55

P4-6 Retained earnings statement, prior period adjustment Moderate 25–35

P4-7 Income statement, irregular items Moderate 25–35

CA4-1 Identification of income statement deficiencies Simple 20–25

CA4-2 Earnings management Moderate 20–25

CA4-3 Earnings management Simple 15–20

CA4-4 Income reporting items Moderate 30–35

CA4-5 Identification of income statement weaknesses Moderate 30–40

CA4-6 Classification of income statement items Moderate 20–25

CA4-7 Comprehensive income Simple 10–15

LEARNING OBJECTIVES

1 Understand the uses and limitations of an income statement

2 Describe the content and format of the income statement

3 Prepare an income statement

4 Explain how to report various income items

5 Explain where to report earnings per share information

6 Understand the reporting of accounting changes and errors

7 Prepare a retained earnings statement

8 Explain how to report other comprehensive income

CHAPTER REVIEW

1 Chapter 4 presents a detailed discussion of the concepts and techniques that underlie thepreparation of the income statement and retained earnings statement and the reporting ofother comprehensive income The requirements for adequate presentation of reported netincome are described and illustrated throughout the chapter

2 (L.O 1) The income statement helps users of financial statements (1) evaluate the past 

performance of the company, (2) provide a basis for predicting future performance, and(3) help assess the risk or uncertainty of achieving future cash flows The limitations ofthe income statement include (1) companies omit items from the income statement thatthey cannot measure, (2) income numbers are affected by the accounting methodsemployed, and (3) income measurement involves judgment

3 Quality of earnings is important because markets are based on trust and it is imperativethat investors have faith in the numbers reported If that trust is damaged, capital marketswill be damaged

Elements of the Income Statement

4 (L.O 2) The major elements of net income are: revenues, expenses, gains, and losses.

The distinction between revenues and gains and the distinction between expenses andlosses depend to a great extent on the typical activities of a business enterprise Wheninflows or enhancements of assets result from typical business activities (generally theactivities the entity is in business to perform), revenues result Likewise, outflows or theusing up of assets resulting from typical business activities will generate expenses.Nontypical business activities resulting in inflows or outflows of assets will normallygenerate transactions classified as gains or losses

Income Statement Formats

5 (L.O 3) The income statement may be presented in the   single-step format or the multiple-step format Single-step income statements derive their name from the fact that

total costs and expenses are subtracted from total revenues in a “single step” to arrive at netincome Income taxes are normally shown as a separate item among the expenses (usuallylast) to indicate their relationship to income before taxes The multiple-step format separatesresults achieved by regular operations of the entity from those obtained by nonoperatingactivities Expenses are also classified by function such as cost of sales, selling, andadministrative The multiple-step format provides more information to financial statementusers than does the single-step format; however, both are found in actual practice

6 An income statement is composed of various sections that relate to different aspects ofthe earning process The seven sections identified in the chapter, in the general order oftheir appearance in the income statement, are:

(1) Operating Section Revenues and expenses from the entity’s principal operations. 

a Sales or revenue section

(2) Nonoperating Section  Revenues and expenses resulting from secondary or auxiliaryactivities of the company.

a Other revenues and gains

b Other expenses and losses

(3) Income Tax  All taxes levied on income from continuing operations

(4) Discontinued Operations  Material gains and losses resulting from disposal of

a segment of the business

(5) Extraordinary Items  Unusual and infrequent material gains and losses

(6) Noncontrollable Interest

(7) Earnings per Share.

7 Condensed income statements Includes only totals of expense groups Supplementary

schedules support the totals

Reporting Various Income Items

8 (L.O 4) For the most part, accountants tend to agree on the composition of items included 

on the income statement However, certain unusual items (irregular gains/losses) havestirred controversy in regard to the effect they should have on the presentation of netincome Some accountants favor reporting the unusual items directly in the income

statement Those who support the current operating performance concept to income

measurement believe that the unusual items should be closed directly to retained

earnings (not included in computing net income) The accounting profession adopted a

modified all-inclusive concept and requires application of this approach in practice.

9 In an attempt to provide financial statement users with the ability to better determine thelong-range earning power of an enterprise, certain professional pronouncements requirethat the following irregular items be highlighted in the financial statements

Unusual Gains and Losses

10 Material gains and losses that are either unusual or occur infrequently, but not both, are

excluded from the extraordinary item classification These items are presented with thenormal, recurring revenues, costs, and expenses If material, these items are disclosedseparately; if immaterial, they may be combined with other items in the income statement

Discontinued Operations

11 A discontinued operation occurs when (a) a company eliminates the results of

operations of a component of the business, and (b) there is no significant continuinginvolvement in that component after the disposal transaction When an entity decides todispose of a component of its business, certain classification and disclosure requirementsmust be met A separate income statement category for gain or loss from disposal of acomponent of a business must be provided In addition, the results of operations of acomponent that has been or will be disposed of are also reported separately fromcontinuing operations

Intraperiod Tax Allocation

12 Intraperiod tax allocation is the process of relating the income tax effect of an unusual

item to that item when it appears on the income statement Income tax expense related to

continuing operations is shown on the income statement at its appropriately computed

amount All other items included in the determination of net income should be shown net

of their related tax effect The tax amount may be disclosed in the income statement or in

a footnote

Extraordinary Items

13 Extraordinary items are defined as material items that are unusual in nature and occur

infrequently Both characteristics must exist for an item to be classified as an

extraordinary item on the income statement Only rarely does an event or transactionclearly meet both criteria and thus give rise to an extraordinary gain or loss If an event ortransaction meets both tests, it is shown net of taxes in a separate section of the incomestatement usually just above net income

Noncontrolling Interest

14 Noncontrolling interest is the portion of equity (net assets) interest in a subsidiary not

attributable to the parent company

Earnings per Share

15 (L.O 5) In general,   earnings per share represents the ratio of net income minus preferred

dividends (income available to common shareholders) divided by the weighted averagenumber of common shares outstanding It is considered by many financial statement users

to be the most significant statistic presented in the financial statements, and must be

disclosed on the face of the income statement Per share amounts for gain or loss on

discontinued operations and gain or loss on extraordinary items must be disclosed on theface of the income statement or in the notes to the financial statements

Changes in Accounting Principles

16 (L.O 6) A change in accounting principle results when a company adopts a new

accounting principle that is different from the one previously used A company recognizes a

change in accounting principle by making a retrospective adjustment to the financial

statements Such an adjustment recasts the prior years’ statements on a basis consistentwith the newly adopted principle The company records the cumulative effect of the changefor prior periods as an adjustment to beginning retained earnings of the earliest yearpresented

Changes in Estimates

17 Accountants make extensive use of estimates in preparing financial statements Adjustmentsthat grow out of the use of estimates in accounting are used in the determination ofincome for the current period and future periods and are not charged or credited directly

to Retained Earnings It should be noted that changes in estimates are not considered

errors (prior period adjustments) nor extraordinary items

Corrections of Errors

18 Companies must correct errors by making proper entries in the accounts and reportingcorrections in the financial statements Corrections of errors are treated as prior periodadjustments, similar to changes in accounting principles Companies record an error inthe year in which it is discovered They report the effect of the error as an adjustment tothe beginning balance of retained earnings If a company prepares comparative financialstatements, it should restate the prior statements for the effects of the error

Retained Earnings

19 (L.O 7) The   retained earnings statement serves to reconcile the balance of the retained

earnings account from the beginning to the end of the year The important informationcommunicated by the retained earnings statement includes: (a) prior period adjustments(income or loss related to corrections of errors in the financial statements of a prior periodnet of tax), (b) changes in accounting principle, (c) the relationship of dividend distributions

to net income for the period, and (d) any transfers to and from retained earnings

Comprehensive Income

20 (L.O 8) Items that bypass the income statement are included under the concept of 

comprehensive income Comprehensive income includes all changes in equity during

a period except those resulting from investments by owners and distributions to owners

21 The FASB requires that the components of other comprehensive income must bedisplayed in one of two ways: (1) a one statement approach, or (2) a two statement

approach In the one statement approach, the traditional net income is a subtotal, with

total comprehensive income shown as a final total The combined statement has the

advantage of not requiring the creation of a new financial statement The two statement

format reports comprehensive income in a separate statement, which indicates that the

gains and losses identified as other comprehensive income have the same status astraditional gains and losses

Statement of Stockholders’ Equity

22 This statement reports the changes in each stockholders’ equity account and in totalstockholders’ equity during the year Both contributions (issuances of shares) anddistributions (dividends) to owners, and a reconciliation of the carrying amount of eachcomponent of stockholders’ equity from the beginning to the end of the period aredisclosed in the statement

LECTURE OUTLINE

The material in this chapter can be covered in two to three class sessions Most students havehad previous exposure to the concepts presented in the chapter

The lecture and assigned problems should be directed toward three areas of concentration:

1 An understanding of the concepts underlying the measurement and presentation of income.These include concepts such as the quality of earnings, the modified all-inclusive approachversus the current operating performance approach, etc

2 An understanding of each of the intermediate components of income and other variousincome items, including prior period adjustments, extraordinary items, discontinuedoperations etc Students should be able to: (1) recognize these items when encountered inproblem material, and (2) identify the proper accounting and disclosure procedure for each

state-A (L.O 1) Uses and Limitations of an Income Statement. 

1 The income statement helps investors and creditors predict the amounts, timing, and

uncertainty of future cash flows Income statement information is useful for:

about the various components of income—revenues, expenses, gains, and losses

—is helpful for assessing the likelihood of achieving a particular level of cashflows in the future

B Limitations of the Income Statement

For example:

a Unrealized gains and losses on certain investment securities

b The value of brand recognition, customer service, and product quality

concept of the quality of earnings.

a Discuss how earnings management can affect the quality of earnings

3 Income measurement involves judgment Discuss this in terms of bad debt expense

and depreciation expense

C Quality of Earnings

to smooth out bumps in earnings

2 Quality of earnings is important because markets rely on trust Investors losing faith inthe numbers reported in the financial statements will damage U.S capital markets

3 The SEC has taken decisive action to prevent the practice of earnings management

D Format of the Income Statement

1 The elements of the income statement are revenues, expenses, gains, and losses.

2 Income statement formats

a (L.O 2) Single-step format

Use Illustration 4-2 to describe the sections of the multiple-step income statement format.

Emphasize the intermediate components such as gross profit, income from operations, andother revenues and expenses

c Point out that the difference between the two formats affects only the presentation

of items before income from continuing operations

d GAAP permits either the multiple-step or single-step format

e Condensed income statements Used when the amount of expense detailprevents a conveniently sized income statement See Illustration 4-3 on page 166

of the text

3 (L.O 4) Reporting Irregular Items:   Presentation of items after income from continuing

operations

T EACHING T IP Illustration 4-3 can be used to discuss each of the special items after income from

continuing operations Emphasize that separate disclosures of these items are the result ofpronouncements by the accounting profession

Developing a framework for reporting irregular items is important to ensure reliableincome information

a The current operating performance approach   requires that net income should

include only regular, recurring earnings from normal operations Irregular gainsand losses should be closed directly to retained earnings

b The accounting profession has adopted a modified all-inclusive concept and

requires application of this approach in practice This approach requires thatcompanies record most items, including irregular ones, as part of net income

E Unusual Gains and Losses Items that are unusual or infrequent, but not both.

1 Companies report unusual items in the “Other revenues and gains” or “Other expensesand losses” section

2 These items may not be presented net of tax.

F Discontinued Operations Results from disposal of a component of the business.

1 A discontinued operation occurs when two things happen: (1) a company eliminates

the results of operations of a component of the business, and (2) there is no significantinvolvement in that component after the disposal transaction

2 Examples of disposals of a component are:

a A sale by a diversified company of a major division which represents the company’sonly activities in the electronics industry The assets and results of operations of thedivision are clearly segregated for internal financial reporting purposes from theother assets and results of operations of the company

b A sale by a meat packing company of a 25% interest in a professional footballteam which has been accounted for under the equity method All other activities ofthe company are in the meat packing business

c A sale by a communications company of all its radio stations which represent 30% ofgross revenues The company’s remaining activities are three television stations and

a publishing company The assets and results of operations of the radio stations areclearly distinguishable physically, operationally, and for financial reporting purposes

d A food distributor disposes of one of its two divisions One division sells foodwholesale primarily to supermarket chains and the other division sells food

through its chain of fast food restaurants, some of which are franchised and some

of which are company-owned Both divisions are in the business of distribution offood However, the nature of selling food through fast food outlets is vastly differentthan that of wholesaling food to supermarket chains

3 Disposals that do not qualify as disposals of a component are:

a The sale of a major foreign subsidiary engaged in silver mining by a mining companywhich represents all of the company’s activities in that particular country Eventhough the subsidiary being sold may account for a significant percentage of grossrevenue of the consolidated group and all of its revenues in the particular country,the fact that the company continues to engage in silver mining activities in othercountries would indicate that there was a sale of only a part of a line of business

b The sale by a petrochemical company of a 25% interest in a petrochemical plantwhich is accounted for as an investment in a corporate joint venture under theequity method Since the remaining activities of the company are in the same line

of business as the 25% interest which has been sold, there has not been a sale of

a major line of business but rather a sale of part of a line of business

c A manufacturer of children’s wear discontinues all of its operations in Italy whichwere composed of designing and selling children’s wear for the Italian market Inthe context of determining a component of a business by class of customer, thenationality of customers or slight variations in product lines in order to appeal toparticular groups are not determining factors

d A diversified company sells a subsidiary which manufactures furniture The companyhas retained its other furniture manufacturing subsidiary The disposal of thesubsidiary, therefore, is not a disposal of a component of the business but rather adisposal of part of a line of business

e The sale of all the assets (including the plant) related to the manufacture of men’swoolen suits by an apparel manufacturer in order to concentrate activities in themanufacture of men’s suits from synthetic products This would represent a disposal

of a product line as distinguished from the disposal of a major line of business

4 Disposals of a component are reported net of tax in the income statement immediatelybelow income from continuing operations Results of the disposal are reported in twoamounts

a Income or loss from operation of the component that has been or will be

disposed of, net of tax

1 Intraperiod tax allocation involves a breakdown of total income tax expense into

separate components which are disclosed in different portions of the financialstatements Intraperiod tax allocation is applied to:

a Income from continuing operations

b Discontinued operations

c Extraordinary items

2 Use the income statement on text page 172 to demonstrate intraperiod tax allocation.Ask students to compute the total income tax expense for 2014 It is $167,800,disclosed for accounting purposes as follows:

Tax associated with continuing operations $184,000

Tax on operations of discontinued division 24,800

Reduction of tax due to loss on disposal of

discontinued division (41,000 )Total income tax expense $167,800

Without intraperiod tax allocation, total income tax expense would merely be reported

as $167,800 and financial statement users would not be able to assess the tax quences of operations or of irregular items

conse-3 Point out that the net-of-tax amount of an item is calculated by multiplying the item by(1 minus the tax rate)

H Extraordinary Items Nonrecurring material items that are unusual in nature and

infrequent in occurrence, considering the environment in which the entity operates

1 Examples of extraordinary items are:

a A large portion of a tobacco manufacturer’s crops is destroyed by a hail storm.Severe damage from hail storms in the locality where the manufacturer growstobacco is rare

b A steel fabricating company sells the only land it owns The land was acquired tenyears ago for future expansion, but shortly thereafter the company abandoned allplans for expansion and held the land for appreciation

c A company sells a block of common stock of a publicly traded company Theblock of shares, which represents less than 10% of the publicly-held company, isthe only security investment the company has ever owned

d An earthquake destroys one of the oil refineries owned by a large multi-national oilcompany

2 Examples of items that are not extraordinary are: