Income Statement and Related Information

1. Income Statement and Related Information Chapter 4 Intermediate Accounting Kieso, Weygandt, and Warfield

2. Learning Objectives • Understand the uses and limitations of an income statement. • Prepare a single-step income statement. • Prepare a multiple-step income statement. • Explain how to report irregular items. • Explain intraperiod tax allocation. • Identify where to report earnings per share information. • Prepare a retained earnings statement. • Explain how to report other comprehensive income.

3. Income Statement and Related Information Income Statement Format of the Income Statement Reporting Irregular Items Special Reporting Issues Usefulness Limitations Quality of Earnings Elements Single-step Multiple-step Condensed income statements Discontinued operations Extraordinary items Unusual gains and losses Changes in accounting principles Changes in estimates Corrections of errors Intraperiod tax allocation Earnings per share Retained earnings statement Comprehensive income

4. Elements of the Income Statement – Inflows or other enhancements of assets or settlements of its liabilities that constitute the entity’s ongoing major or central operations. (e.g., sales revenue, service revenue, rent revenue, interest revenue, dividend revenue) – Outflows or other using-up of assets or incurrences of liabilities that constitute the entity’s ongoing major or central operations. (e.g., cost of goods sold, salaries expense, depreciation expense, etc.) – Increases in equity (net assets) from peripheral or incidental transactions. - Decreases in equity (net assets) from peripheral or incidental transactions. [Note: Gains and Losses result from events such as sales of long-term assets (e.g., PP&E), write-offs of assets, and settlement of liabilities]

5. Single Step Income Statement

6. Multiple Step Income Statement (e.g. salesperson’s salary, advertising, or depreciation on the salesperson’s car) < (e.g., depreciation on office furniture or accountants’ salaries) (not generated or used by operations, typically interest revenue / expense and gains and losses)

7. Reporting Irregular Items • Irregular items that impact net income and/or stockholders’ equity fall into six categories: • Unusual gains and losses • Discontinued operations • Extraordinary items • Changes in accounting principle • Changes in estimates • Corrections of errors

8. Unusual Gains And Losses • Material items that are unusual or infrequent, should be reported above income before income taxes (oftentimes in the ‘Other revenues and expenses’ category). • Examples can include: • Write-downs of inventories • Foreign exchange transaction gains and losses • Since these items are reported before the Income Tax Expense line item on the Income Statement, they are not reported net-of-tax.

9. Discontinued Operations ’Discontinued Operations’ is a category used on the income statement - The segment must be a portion of the business - The sale must change the nature of operations in a way that affects the ability of users of financial statements to predict future activities - Discontinued operations are reported net of tax on the income statement below income from continuing operations. Disclosure for discontinued operations include: - Show the results from operations of the discontinued segment (net of taxes), up until the date of disposal. - Show the gain or loss on the disposal (net of taxes) (Note that a loss in either category produces a tax savings or benefit)

10. Extraordinary Items An extraordinary item relates to an event or transaction To determine whether an item meets the criteria as being extraordinary depends on the context forthat company. - Requires on the part of the company’s management in determining whether an event or transaction should be classified as extraordinary or not. Extraordinary items are presented on the income statement net of tax below income from operations or income from continuing operations.

11. Changes In Accounting Principle Sometimes companies will make changes in their accounting treatment from one period to the next. Such changes in accounting principle are treated (i.e., the prior years’ financial statements that are presented are as if the new accounting method used was used in prior periods as well; this treatment improves

12. Changes In Accounting Principle – cont’d Assume a company changed from FIFO to LIFO BALANCE SHEET F/S: F/S: -------------------------------------------------------------------------- INCOME STATEMENT F/S: F/S: The cumulative effect of the change (net of tax) for periods prior to the first year presented is treated as an adjustment to the beginning balance of for the earliest year presented.

13. Changes In Estimates Sometimes companies will make changes in their accounting estimates. Such changes in accounting estimates are treated (i.e., the prior years’ financial statements are; rather such changes will only affect periods’ financial statements, beginning with the financial statements in the year of the change). For example, assume machinery that cost $100,000 was originally estimated to have a useful life of 10 years. After 4 years, the company now believes it will last only 8 years.

14. Corrections Of Errors Sometimes companies make errors or mistakes in preparing their financial statements (e.g.,mathematical, applying accounting rules) - If a company prepares comparative financial statements, it should for the effects of the error. For example, assume that at the end of the year a company realized that they recognized revenues improperly for the last 5 years. The current year’s income statement would show: Sales - The net effect on income from the error (i.e., net of tax) for periods prior to the first period presented is treated as a to the beginning balance of

15. Detailed Multiple Step Income Statement Net Sales - Cost of Goods Sold Gross Profit - Operating Expenses Income from Operations +Other Revenues/Expenses Income Before Income Taxes - Income Tax Expense Income from Continuing Operations +/- Income (loss) from Discontinued Operations (net of tax) +/- Extraordinary gains or losses (net of tax) Net Income

16. Intraperiod Tax Allocation • Relates the income tax expense to the specific items that • give rise to the amount of the tax expense. • Income tax is allocated to the following items: • (1)Income from continuing operations before tax • (2) Discontinued operations (i.e., reported net of tax) • (3) Extraordinary items (i.e., reported net of tax) • (4)Changes in accounting principle • (i.e., if the effects are prior to the first period presented the cumulative effect, net of tax, is reported as an adjustment to beginning retained earnings) • (5)Correction of errors • (i.e., prior period adjustments for periods prior to the first period presented are reported, net of tax, as an adjustment to beginning retained earnings)

17. Comprehensive Income Comprehensive Income represents all changes induring a period except those resulting from by owners and to owners. The primary component of Comprehensive Income is typically Gains and losses that bypass net income (e.g., unrealized gains and losses on available-for-sale securities) but affect stockholders' equity are referred to as There are different acceptable approaches to reporting Comprehensive Income, as illustrated on the following slides.

18. Comprehensive Income Comprehensive Income Illustration 4-19 Second income statement

19. Comprehensive Income Comprehensive Income Combined statement

20. Comprehensive Income Comprehensive Income – Balance Sheet Presentation Regardless of the display format used, the accumulated other comprehensive income of $90,000 is reported in the stockholders’ equity section of the balance sheet.

21. Income Statement Usefulness of the Income Statement • Evaluate past performance. • Predict future performance. • Help assess the risk or uncertainty of achieving future cash flows. Limitations of the Income Statement • Companies omit items that cannot be measured reliably. • Income is affected by the accounting methods employed. • Income measurement involves judgment.

22. Quality of Earnings A significant ethical issue the accounting profession faces is that companies have incentives to manage income to meet or beat Wall Street expectations. Earnings quality is reduced if earnings management results in information that is less useful for predicting future earnings and cash flows.