The Income
Statement and
Statement of
Cash Flows
4
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
4-2
Learning Objectives
Explain the difference between net income and
comprehensive income and how we report
components of the difference.
4-3
Comprehensive Income
An expanded
version of income
that includes four
types of gains and
losses that
traditionally have
not been included
in income
statements.
4-4
Other Comprehensive Income
Statement of Financial Accounting Standards No. 130
Comprehensive income includes traditional net income
and changes in equity from nonowner transactions.
1. Changes in the market value of securities available for sale
(described in Chapter 12).
2. Gains, losses, and amendment costs for pensions and other
postretirement plans (described in Chapter 17).
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 (described in
Chapter 14).
4. Gains or losses from changes in foreign currency exchange rates
(discussed elsewhere in your accounting curriculum).
4-5
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.
FedEx Corporation
Balance Sheet
31-May
(In millions, except shares)
Common Stockholders' Investment:
Common stock, $.10 par value, 800 million
shares authorized, 300 million shares
issued for 2004 and 299 million shares
issued for 2003
Additional paid-in capital
Retained earnings
Accumulated other comprehensive loss
Less deferred compensation and treasury
stock at cost
Total common stockholders' investment
2004
$
$
2003
30 $
30
1,079
7,001
(46)
8,064
1,088
6,250
(30)
7,338
28
8,036 $
50
7,288
4-6
Learning Objectives
Discuss the importance of income from
continuing operations and describe its
components.
4-7
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.
Operating Income 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
4-8
4-9
Income Statement (Single-Step)
{
Proper Heading
Revenues
& Gains
Expenses
& Losses
{
{
MAXWELL GEAR COMPANY
Income Statement
For the Year Ended December 31, 2006
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
4-10
Income Statement (Multiple-Step)
{
Proper Heading
Gross
Profit
Operating
Expenses
Nonoperating
Items
{
{
{
MAXWELL GEAR CORPORATION
Income Statement
For the Year Ended December 31, 2006
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
$
47,341
24,888
16,300
573,522
302,371
271,151
88,529
182,622
26,400
5,500
(6,200)
(8,322)
$
17,378
200,000
80,000
120,000
4-11
Learning Objectives
Describe earnings quality and how it is
impacted by management practices to
manipulate earnings.
4-12
Earnings Quality
Earnings quality refers to
the ability of reported
earnings to predict a
company’s future.
The relevance of any
historical-based financial
statement hinges on its
predictive value.
4-13
Manipulating Income and Income Smoothing
“Most managers prefer to report earnings that follow a
smooth, regular, upward path.”1
Two ways to manipulate income:
1. Income shifting
2. Income statement
classification
1
Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p. 168.
4-14
Learning Objectives
Discuss the components of operating and
nonoperating income and their relationship to
earnings quality.
4-15
Operating Income and Earnings Quality
Should all items of revenue and expense included in
operating income be considered indicative of a
company’s permanent earnings?
No, not necessarily.
Operating expenses may include the following unusual items
that may or may not continue in the future:
• Restructuring costs
• Goodwill impairment
• Long-lived asset impairment
• In-process research and development
4-16
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 (discussed further in
Chapters 10 & 11).
In-process Research
and Development
Results from certain business
combinations (discussed further in
Chapter 10).
4-17
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?
4-18
Pro Forma Earnings
Companies often voluntarily provide a pro forma
earnings number when they announce annual or
quarterly earnings. Pro forma earnings are
management’s assessment of permanent earnings.
The Sarbanes-Oxley Act
Section 401 requires a
reconciliation between pro
forma earnings and
earnings determined
according to GAAP.
4-19
Separately Reported Items
Reported separately, net of taxes:
Discontinued
operations
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
Extraordinary
items
$ xxx
xx
xxx
xx
xx
$ xxx
A third item, the
cumulative effect of
a change in
accounting
principle, was
eliminated from
separate reporting
by a new
accounting
standard in 2005.
4-20
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.
4-21
Learning Objectives
Define what constitutes discontinued
operations and describe the appropriate
income statement presentation for these
transactions.
4-22
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
4-23
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.
4-24
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.
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.
4-25
Discontinued Operations Example
During the year, Apex Co. sold an
unprofitable component of the company. The
component had a net loss from operations
during the period of $150,000 and its assets
sold at a loss of $100,000. Apex reported
income from continuing operations of
$128,387. All items are taxed at 30%.
How will this appear in the income
statement?
4-26
Discontinued Operations Example
Computation of Loss from Discontinued Operations
(Net of Tax Effect):
Loss from discontinued operations
Less: Tax benefit ($150,000 × 30%)
Net loss
$
Loss on disposal of assets
Less: Tax benefit ($100,000 × 30%)
Net loss
$
$
$
(150,000)
45,000
(105,000)
(100,000)
30,000
(70,000)
4-27
Discontinued Operations Example
Income Statement Presentation:
Income from continuing operations
Discontinued operations:
Loss from operations of discontinued
component (net of tax benefit of
$45,000)
Loss on disposal of discontinued
component (net of tax benefit of
$30,000)
Net loss
$ 128,387
(105,000)
(70,000)
$ (46,613)
4-28
Learning Objectives
Define extraordinary items and describe the
appropriate income statement presentation for
these transactions.
4-29
Extraordinary Items
 Material
events or
transactions
 Unusual in nature
 Infrequent in occurrence
 Reported net of related
taxes
4-30
Extraordinary Items Example
During the year, Apex Co. experienced a
loss of $75,000 due to an earthquake at one
of its manufacturing plants in Nashville.
This was considered an extraordinary item.
The company reported income before
extraordinary item of $128,387. All gains
and losses are subject to a 30% tax rate.
How would this item appear in the
income statement?
4-31
Extraordinary Items Example
Computation of Loss from Extraordinary Item (Net of
Tax Effect):
Extraordinary Loss
Less: Tax Benefits
($75,000 × 30%)
Net Loss
$ (75,000)
22,500
$ (52,500)
Income Statement Presentation:
Income before extraordinary item
Extraordinary Loss:
Earthquake loss
(net of tax benefit of $22,500)
Net income
$ 128,387
(52,500)
$ 75,887
4-32
Unusual or Infrequent Items
Items that are material and are either
unusual or infrequent—but not both—
are included as a separate item in
continuing operations.
4-33
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
4-34
Learning Objectives
Describe the measurement and reporting
requirements for a change in accounting
principle.
4-35
Change in Accounting Principle

Occurs when changing from one GAAP
method to another GAAP method

For example, a change from LIFO to FIFO

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 the
same way as a change in accounting
estimate.
4-36
Learning Objectives
Explain the accounting treatments of changes
in estimates and correction of errors.
4-37
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
4-38
Change in Accounting Estimate Example
On January 1, 2003, we purchased
equipment costing $30,000, with a useful
life of 10 years and no salvage value.
During 2006, we determine that the
remaining useful is 5 years (8-year total
life). We use straight-line depreciation.
Compute the revised depreciation
expense for 2006.
4-39
Change in Accounting Estimate Example
Asset cost
Accumulated depreciation
12/31/05 - ($3,000 × 3 years)
Remaining to be depreciated
Remaining useful life
Revised annual depreciation
GENERAL JOURNAL
$
30,000
$
(9,000)
21,000
÷ 5 years
4,200
Page: 180
Credit
Description
PR
Debit
Record
depreciation
expense
of
$4,200
for
Depreciation Expense
4,200
2006 andDepreciation
subsequent years.
Accumulated
4,200
Date
4-40
Change in Reporting Entity
If two entities
combine, a single
set of consolidated
financial
statements is
generally required.
4-41
Change in Reporting Entity
A change in reporting
entity is reported by
restating all previous
periods’ financial
statements presented
for comparative
purposes as if the new
reporting entity existed
in those periods.
4-42
Prior Period Adjustments
 Corrections
of errors from a
previous period
 Appear
in the Statement of
Retained Earnings as an
adjustment to beginning
retained earnings
 Must
show the adjustment
net of income taxes
4-43
Prior Period Adjustments Example
While reviewing the depreciation entries for
2002-2007, the controller found that in 2006
depreciation expense was incorrectly debited
for $150,000 when in fact it should have been
debited $125,000. (Ignore income taxes.)
GENERAL JOURNAL
Date
Description
12/31/06 Depreciation Expense
Accumulated Depreciation
PR
Debit
Page: 180
Credit
150,000
150,000
Prepare the necessary journal entry in 2007 to
correct this prior period error.
4-44
Prior Period Adjustments Example
GENERAL JOURNAL
Date
Description
PR
Debit
Page: 180
Credit
2007 Entry
Accumulated Depreciation
Retained Earnings
25,000
25,000
4-45
Learning Objectives
Define earnings per share (EPS) and explain
required disclosures of EPS for certain income
statement components.
4-46
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.
4-47
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
4-48
Learning Objectives
Describe the purpose of the statement of cash
flows.
4-49
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
presented.
4-50
Learning Objectives
Identify and describe the various classifications
of cash flows presented in a statement of cash
flows.
4-51
Operating Activities
Inflows from:

Sales to customers.
 Interest and dividends
received.
+
Outflows to:




Purchase of inventory.
Salaries, wages, and other
operating expenses.
Interest on debt.
Income taxes.
_
Cash
Flows
from
Operating
Activities
4-52
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
4-53
Direct and Indirect Methods
ARLINGTON LAWN CARE
Statement of Cash Flows
For the Year Ended December 31, 2006
($ 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
(25)
$ 53
Direct
Method
ARLINGTON LAWN CARE
Statement of Cash Flows
For the Year Ended December 31, 2006
($ in thousands)
Cash flows from Operating Activities
Net income
$
Adjustments for noncash effects:
Depreciation expense
$
8
Increase in accounts receivable
(12)
Increase in accounts payable
7
Increase in income taxes payable
15
Net cash flows from operating activities
$
35
18
53
4-54
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 to:

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
4-55
Financing Activities
Inflows from:


Sale of shares to owners.
Borrowing from creditors
through notes, loans,
mortgages, and bonds.
+
Outflows to:



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
4-56
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).
4-57
End of Chapter 4