Chapter 4
THE INCOME STATEMENT
AND STATEMENT OF CASH
FLOWS
McGraw-Hill /Irwin
© 2009 The McGraw-Hill Companies, Inc.
Slide 2
Income from Continuing Operations
Revenues
Expenses
Inflows of
resources
resulting
from
providing
goods or
services to
customers.
Outflows of
resources
incurred in
generating
revenues.
Gains and
Losses
Income Tax
Expense
Increases or
decreases in
equity from
peripheral or
incidental
transactions
of an entity.
Because of
its
importance
and size,
income tax
expense is a
separate
item.
4-2
Slide 3
Operating Versus Nonoperating Income
Operating
Income
Nonoperating
Income
Includes revenues
and expenses
directly related to
the principal
revenuegenerating
activities of the
company
Includes gains
and losses and
revenues and
expenses related
to peripheral or
incidental
activities of the
company
4-3
Slide 4
Income Statement (Single-Step)
{
Proper Heading
Revenues
& Gains
Expenses
& Losses
{
{
MAXWELL GEAR CORPORATION
Income Statement
For the Year Ended December 31, 2009
Revenues and gains:
Sales
Interest and dividends
Gain on sale of opearting assets
Total revenues and gains
Expenses and losses:
Cost of goods sold
Selling
General and administrative
Research and development
Interest
Loss on sale of investment
Income taxes
Total expenses & losses
Net income
$
$
573,522
26,400
5,500
605,422
302,371
47,341
24,888
16,300
6,200
8,322
80,000
$
485,422
120,000
4-4
Slide 5
Income Statement (Multiple-Step)
Proper
Heading
Gross
Profit
Operating
Expenses
Nonoperating
Items
{
{
{
{
MAXWELL GEAR CORPORATION
Income Statement
For the Year Ended December 31, 2009
Sales revenue
Cost of goods sold
Gross profit
Operating expenses:
Selling
General and administrative
Research and development
Operating income
Other income (expense):
Interest and dividend revenue
Gain on sale of operating assets
Interest expense
Loss on sale of investments
Income before income taxes
Income tax expense
Net income
$ 573,522
302,371
271,151
$ 47,341
24,888
16,300
$ 26,400
5,500
(6,200)
(8,322)
88,529
182,622
17,378
200,000
80,000
$ 120,000
4-5
Slide 6
Earnings Quality
Earnings quality refers to the ability of
reported earnings to predict
a company’s future earnings.
Transitory Earnings
versus
Permanent Earnings
4-6
Slide 7
Manipulating Income and Income Smoothing
Two ways to manipulate income:
1. Income shifting
2. Income statement classification
4-7
Slide 8
Operating Income and Earnings Quality
Restructuring Costs
Costs associated with shutdown or
relocation of facilities or
downsizing of operations are
recognized in the period incurred.
Goodwill Impairment
and Long-lived Asset
Impairment
Involves asset impairment losses
or charges.
4-8
Slide 9
Nonoperating Income and Earnings Quality
Gains and losses from the sale of operational
assets and investments often can significantly
inflate or deflate current earnings.
Example
As the stock market boom reached
its height late in the year 2000,
many companies recorded large
gains from sale of investments
that had appreciated significantly
in value.
How should
those gains be
interpreted in
terms of their
relationship to
future
earnings? Are
they transitory
or permanent?
4-9
Slide 10
Separately Reported Items
Reported separately, net of taxes:
Discontinued
operations
Extraordinary
items
Income from continuing operations
before income taxes and
extraordinary items
Income tax expense
Income from continuing operations
before extraordinary items
Discontinued operations (net of $xx
in taxes)
Extraordinary items (net of $xx in
taxes)
Net Income
$ xxx
xx
xxx
xx
xx
$ xxx
4-10
Slide 11
Intraperiod Income Tax Allocation
Income Tax Expense must be associated with
each component of income that causes it.
Show Income Tax
Expense related to
Income from
Continuing
Operations.
Report effects of
Discontinued Operations
and Extraordinary Items
NET OF RELATED
INCOME TAXES.
4-11
Discontinued Operations



A discontinued operation is the sale or
disposal of a component of an entity.
A component comprises operations and
cash flows that can be clearly
distinguished, operationally and for
financial reporting purposes, from the rest
of the entity.
A component could include:
 reportable segments
 operating segments
 reporting units
 subsidiaries
 asset groups
4-12
Discontinued Operations
Report results of operations separately if two
conditions are met:
The operations and
cash flows of the
component have been
(or will be) eliminated
from the ongoing
operations.
The entity will not have
any significant
continuing involvement
in the operations of the
component after the
disposal transaction.
4-13
Discontinued Operations
Reporting for Components Sold
Operating income or
loss of the component
from the beginning of
the reporting period to
the disposal date.
Gain or loss on the
disposal of the
component’s assets.
Reporting for Components Held For Sale
Operating income or
loss of the component
from the beginning of
the reporting period to
the end of the reporting
period.
An “impairment loss” if
the carrying value of
the assets of the
component is more
than the fair value
minus cost to sell.
4-14
Extraordinary Items
Material events or transactions
 Unusual in nature
 Infrequent in occurrence
 Reported net of related taxes

4-15
Unusual or Infrequent Items
Items that are material and are
either unusual or infrequent—but not
both—are included as separate
items in continuing operations.
4-16
Slide 17
Accounting Changes
Type of Accounting
Change
Definition
Change in Accounting
Principle
Change from one GAAP method
to another GAAP method
Change in Accounting
Estimate
Revision of an estimate
because of new information or
new experience
Preparation of financial
statements for an accounting
entity other than the entity that
existed in the previous period
Change in Reporting
Entity
4-17
Change in Accounting Principle

Occurs when changing from one GAAP
method to another GAAP method, for
example, a change from LIFO to FIFO

Most voluntary changes in accounting
principles are accounted for
retrospectively by revising prior years’
financial statements.

Changes in depreciation, amortization, or
depletion methods are accounted for in a
similar way as a change in accounting
estimate.
4-18
Change in Accounting Estimate
Revision of a previous
accounting estimate
Use new estimate in
current and future
periods
Includes treatment for
changes in depreciation,
amortization, and
depletion methods
4-19
Slide 20
Change in Reporting Entity
If two entities
combine, a single
set of consolidated
financial
statements is
generally required.
4-20
Correction of Accounting Errors
Correction of errors from a
previous period
 Appear in the Statement of
Retained Earnings as an
adjustment to beginning
retained earnings (show the
adjustment net of income
taxes)
 Previous years’ financial
statements that are incorrect
are retrospectively restated
to reflect the correction.

4-21
Slide 22
Earnings Per Share Disclosure
One of the most widely used ratios is earnings per
share (EPS), which shows the amount of income
earned by a company expressed on a per share basis.
Basic EPS
Net income less preferred dividends
Weighted-average number of
common shares outstanding for the
period
Diluted EPS
Reflects the potential dilution that could
occur for companies that have certain
securities outstanding that are convertible
into common shares or stock options that
could create additional common shares if
the options were exercised.
4-22
Slide 23
Earnings Per Share Disclosure
Report EPS data separately for:
1. Income from Continuing Operations
2. Separately Reported Items
a) discontinued operations
b) extraordinary Items
3. Net Income
4-23
Slide 24
Comprehensive Income
An expanded
version of income
that includes four
types of gains and
losses that
traditionally have
not been included
in income
statements.
4-24
Slide 25
Other Comprehensive Income
Statement of Financial Accounting Standards No. 130
Comprehensive income includes traditional net income
and changes in equity from nonowner transactions.
1. Net unrealized holding gains (losses) from investments (net of tax).
2. Gains and losses due to reviewing assumptions or market returns
differing from expectations and prior service cost from amending the
postretirement benefit plan.
3. When a derivative is designated as a cash flow hedge is adjusted to
fair value, the gain or loss is deferred as a component of
comprehensive income and included in earnings later, at the same
time as earnings are affected by the hedged transaction.
4. Gains or losses from changes in foreign currency exchange rates.
The amount could be an addition to or reduction in shareholders’
equity. (This item is discussed elsewhere in your accounting
curriculum).
4-25
Slide 26
Accumulated Other Comprehensive Income
In addition to reporting comprehensive income that
occurs in the current period, we must also report these
amounts on a cumulative basis in the balance sheet as
an additional component of shareholders’ equity.
JABIL CIRCUITS INC.
Consolidated Balance Sheets (in part)
Yesrs Ended August 31
(In thousands)
Shareholders' equity:
Common stock
Additional paid-in capital
Retained earnings
Accumulated other comprehensive income
Treasury stock
Total shareholders' equity
2007
$
$
212 $
1,340,687
1,131,403
170,960
(200,251)
2,443,011 $
2006
211
1,265,382
1,116,035
109,898
(200,251)
2,291,275
4-26
The Statement of Cash Flows

Provides relevant information about a
company’s cash receipts and cash
disbursements.

Helps investors and creditors to assess
future net cash flows
liquidity
long-term solvency.

Required for each income statement period
reported.
4-27
Slide 28
Operating Activities
Inflows from:

sales to customers.
 interest and dividends
received.
+
Outflows for:




purchase of inventory.
salaries, wages, and other
operating expenses.
interest on debt.
income taxes.
_
Cash
Flows
from
Operating
Activities
4-28
Slide 29
Direct and Indirect Methods of Reporting
Two Formats for Reporting Operating Activities
Direct Method
Indirect Method
Reports the
cash effects of
each operating
activity
Starts with
accrual net
income and
converts to
cash basis
4-29
Slide 30
Direct and Indirect Methods
ARLINGTON LAWN CARE
Statement of Cash Flows
For the Year Ended December 31, 2009
($ in thousands)
Cash flows from Operating Activities
Cash received from customers
Cash paid for administrative expenses
Net cash flows from operating activities
Indirect
Method
$
78
(29)
$ 49
Direct
Method
ARLINGTON LAWN CARE
Statement of Cash Flows
For the Year Ended December 31, 2009
($ in thousands)
Cash flows from Operating Activities
Net income
$
Adjustments for noncash effects:
Depreciation expense
$
8
Increase in prepaid insurance
(4)
Increase in accounts receivable
(12)
Increase in accounts payable
7
Increase in income taxes payable
15
Net cash flows from operating activities
$
35
14
494-30
Slide 31
Investing Activities
Inflows from:



sale of long-term assets used in
the business.
sale of investment securities
(stocks and bonds).
collection of nontrade
receivables.
+
Outflows for:

purchase of long-term assets
used in the business.
 purchase of investment
securities (stocks and bonds).
 loans to other entities.
_
Cash
Flows
from
Investing
Activities
4-31
Slide 32
Financing Activities
Inflows from:


sale of shares to owners.
borrowing from creditors
through notes, loans,
mortgages, and bonds.
Outflows for:



owners in the form of dividends
or other distributions.
owners for the reacquisition of
shares previously sold.
creditors as repayment of the
principal amounts of debt.
+
_
Cash
Flows
from
Financing
Activities
4-32
Slide 33
Noncash Investing and Financing
Activities
Significant investing and financing
transactions not involving cash
also are reported.
Acquisition of equipment (an investing
activity) by issuing a long-term note
payable (a financing activity).
4-33
End of Chapter 4
McGraw-Hill /Irwin
© 2009 The McGraw-Hill Companies, Inc.