The Income
Statement
2
Learning Objectives
 Define the concept of income.
 Explain why an income measure is
important.
 Explain how income is measured,
including the revenue recognition and
expense-matching concepts.
 Understand the format of an income
statement.
3
Learning Objectives
 Describe the specific components of an
income statement.
 Describe the specific components of an
income statement.
 Compute comprehensive income and
prepare the statement of stockholders’
equity.
 Construct simple forecasts of income
for future periods.
4
Capital Maintenance
• Income per financial capital maintenance:
– Results only if ending balance of owners’
equity (in monetary units) is greater than
beginning balance (in monetary units).
– When trading a specific item, income equals
difference of historical cost and net realizable
value.
5
Capital Maintenance
Kreidler, Inc., had the following
assets and liabilities at the beginning
and at the end of a period.
Total assets
Total liabilities
Net assets
(owners’ equity)
Beginning
of Period
$510,000
End of
Period
$560,000
430,000
390,000
Income is $90,000
$ 80,000
$170,000
6
Capital Maintenance
If the owners invested $40,000 in the
business and received dividends of
$15,000, what would be the income?
Net assets, end of period
Net assets, beginning of period
Increase in net assets
Deduct investment by owners
Add dividends to owners
Income
$170,000
80,000
$ 90,000
(40,000)
15,000
$ 65,000
7
Capital Maintenance
• Income per physical capital maintenance:
– Results only if production capacity at the end of the
period exceeds capacity at the beginning of the
period.
– Capacity is measured by replacement cost of net
assets.
– Income/loss is the difference between replacement
cost and net realizable valuable.
– Difference between historical cost and replacement
cost is considered a capital maintenance adjustment
and not part of income.
8
Example of Capital Maintenance
• Assume purchase of a house:
– Purchase price
– Replacement cost (Year 5)
– Sale price (Year 5)
$ 50,000
150,000
175,000
• Calculate income under financial
capital maintenance and under physical
capital maintenance assumptions.
9
Financial Capital Maintenance
Date
1/1/X0
Assets
$ 50,000
Liabilities
-0-
Equity
$ 50,000
1/1/X5
$175,000
-0-
$175,000
Income (difference of beginning
equity and ending equity)
$125,000
10
Physical Capital Maintenance
Date
1/1/X0
Assets
$ 50,000
Liabilities
-0-
Equity
$ 50,000
1/1/X5
$175,000
-0-
$ 175,000
Change in owners’ equity
Change necessary to allow for
replacement of home
($150,000 - $50,000)
Income
$ 125,000
100,000
$ 25,000
Why Is a Measure of
Income Important?
The recognition, measurement, and
reporting of business income and
its components are considered by
many to be the most important
tasks of accountants.
11
Why Is a Measure of
Income Important?
Will the company be profitable
enough
pay interest on its debt and
WhatWhat
istothe
is
the
most
dividends
to it stockholders
andactivity
still
Has the
trend
of
probable
result
for
grow at the desired
rate?
been
profitable?
profitability?
future years?
12
13
How Is Income Measured?
Income is measured as the difference
between resources inflows (revenues
and gains) and outflows (expenses
and losses) over a period of time.
14
Elements of Income
• Revenue: Inflows or other
enhancements of assets of an entity or
settlements of its liabilities from
delivering or producing goods,
rendering services, or other activities
that constitute the entity’s ongoing,
major or central operations (SFAC
6.78).
15
Elements of Income
• Expense: Outflows or other “using up”
of assets or incurrence of liabilities
from delivering or producing goods,
rendering services, or carrying out
other activities that constitute the
entity’s ongoing major or central
operations (SFAC 6.80).
16
Elements of Income
• Gain: Increase in equity from
peripheral or incidental transactions of
an entity and from all other
transactions . . . except those that result
from revenues or investments by
owners (SFAC 6.82).
17
Elements of Income
• Loss: Decrease in equity from
peripheral or incidental transactions of
an entity and from all other
transactions . . . except those that result
from expenses or distributions to
owners (SFAC 6.83).
18
Elements of Income
• Recognition: The process of formally
recording or incorporating an item in the
financial statements of an entity (SFAC
6.143).
• Realization: The process of converting
noncash resources and rights into money
refers to sales of assets for cash or claims to
cash.
19
Elements of Income
Revenues are recognized when the
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 least a
valid promise of payment.
Recognition Criteria:
Expenses and Losses (SFAC 5.86)
 Direct matching.
 Systematic and
rational allocation.
 Immediate
recognition.
20
Recognition Criteria:
Expenses and Losses (SFAC 5.86)
• Direct Matching: Expenses are
recognized upon recognition of
revenues that result directly and
jointly from the same transaction or
other events as the expenses.
Direct expenses include not only those
that have already been incurred but
should also include anticipated expenses
related to revenues of the current period.
21
Recognition Criteria:
Expenses and Losses (SFAC 5.86)
• Systematic and Rational Allocation:
Costs are allocated by systematic
and rational procedures to periods
during which the related assets are
expected to provide benefits (i.e.,
depreciation).
This category involves assets
that benefit more than one
accounting period.
22
Recognition Criteria:
Expenses and Losses (SFAC 5.86)
• Immediate Recognition: Expenses
are recognized during the period in
which cash is spent or liabilities are
incurred for goods and services (i.e.,
selling and administrative salaries).
This category involves expenses
for goods and services that are
used almost immediately.
23
24
Form of the Income Statement
GAAP requires
certain income
statement
disclosures.
Right, but GAAP
does not require a
specific format.
25
Form of the Income Statement
Revenue
Costs and expenses:
Costs of sales
Single-Step
Selling and administrative
Interest expense
Income
Other income/expense, net
Statement
Restructuring charge
Total costs and expenses
Income before income taxes
Income taxes
Net income
$xxx
$xxx
xxx
xxx
xxx
xxx
$xxx
$ xx
xx
$ xx
26
Form of the Income Statement
Revenue
Costs of goods sold:
Beginning inventory
$xxx
Net purchasesMultiple-Step
xxx
Cost of goods available for sale
$xxx
Income
Less ending inventory
xxx
Statement
Gross profit on sales
Operating expenses:
Selling expenses
$xxx
General expenses
xxx
Operating income Continued on next slide
$xxx
xxx
$xxx
xxx
$xxx
27
Form of the Income Statement
Other revenue and gains
Other expenses and losses
Income from continuing operations before
income taxes
Income taxes on continuing operations
Discontinued operations:
Loss from operations of discontinued
business segment (net of tax)
$xxx
Loss on disposal of segment (net of tax) xxx
Extraordinary gain (net of tax)
Net income
$xxx
(xxx)
$xxx
(xxx)
(xxx)
xxx
$xxx
“Below the Line” Items
GAAP requires certain items be
reported “below the line” and net
of tax.
“Below the line,” or following
Income from Continuing
Operations.
Net of tax requires the tax effect
of the event be shown.
28
“Below the Line” Items
 Discontinued Operations
 Extraordinary Items
 Changes in Accounting
Principles
29
30
Discontinued Operations--Phases
Operating Loss
(net of tax)
$24,500
Loss on Disposal
(net of tax;
includes operating
results 7/1 through
11/17 and loss on
final disposal)
$11,200
Phase-out Period
1/1/02
7/1/02
Measurement
Date
11/17/02 12/31/02
Disposal Statement
Date
Date
Discontinued Operations-Disclosure
• Income statement section consists of
two parts:
– Income (loss) from operations--disclosed
only if decision to discontinue operations
is made after beginning of the year.
– Gain (loss) on disposal of operations-consisting of income (loss) during phaseout and gain (loss) from disposal of
segment assets.
31
Discontinued Operations-Disposal Date After Year End
Measurement
Date
Operating Loss
$4,000
Disposal
Date
32
Statement
Date
Loss on Disposal
$5,000 (including
$2,000 expected
operating loss)
Phase-out Period
8/26/01
8/31/01
4/29/02
12/31/02
Discontinued Operations-Disposal Date After Year End
 Special rules when disposal date is in
year following measurement date.
 A realized “loss on disposal” may be
increased by an estimated loss or it
may be reduced by an estimated gain.
 A realized “gain on disposal” may be
reduced by an estimated loss but
cannot be increased by an estimated
gain.
33
Extraordinary Items-Characteristics
34
Extraordinary Items-Characteristics
Extraordinary
items must be
both unusual and
infrequent...
35
Extraordinary Items-Characteristics
…and material, or
extraordinary by
definition.
36
37
Extraordinary by Definition
• Gain or loss from extinguishment of debt.
• Application of tax carry-forward when tax
benefits are not recognized until realized
in subsequent period.
• If in prior years an item is reported as (1)
disposal of business segment, or (2) as an
extraordinary item, the effect of a reversal
is disclosed in the same manner.
• Unamortized costs of interstate operating
rights.
38
NEVER Extraordinary
Write-down or write-off of receivables,
inventory, etc.
 Translation of foreign exchange or
devaluation.
 Disposal of business segment.
 Sale of productive assets.
 Effects of a strike.
 Adjustment of accruals on long-term
contracts.

Changes in
Accounting Principle
• Report after Extraordinary Items.
• Criteria for change: change only
if the new principle is preferable:
– provides more useful information.
– is less costly per benefit.
39
Changes in Accounting Principle-Disclosure Requirements





40
Report current year’s income components on
the new basis.
Report the cumulative effect of the adjustment
in the current income statement--direct effect
only; net of tax.
Present prior period financial statements as
previously reported.
Include pro forma information as if the change
were retroactive--direct and indirect effects.
Present earnings per share data for all prior
periods presented.
Change of Estimates
 Employ current and prospective
approach.
 Report current and future financial
statements on new basis.
 Present prior periods as previously
reported.
 Make no adjustments to current period
opening balances.
 Present no pro forma data.
41
Change of Principle and
Change of Estimate
If there is both a change in
principle and a change in estimate
for an item, the event is treated as a
change in estimate.
42
43
Return on Sales
1998
1997
1996
AT&T
12.1%
8.6%
11.4%
McDonald’s
12.5%
14.4%
14.7%
IBM
7.8%
7.8%
7.2%
Nike
4.2%
8.7%
8.6%
44
Comprehensive Income
Comprehensive income is the amount
that reflects the change in a company’s
wealth during the period. In addition
to net income, it includes items that, in
general, arise from changes in market
conditions unrelated to the business
operations of a company.
45
Comprehensive Income
The more common adjustments made in
arriving at comprehensive income are:
 Foreign currency translation
adjustments.
 Unrealized gains and losses on
available-for-sale securities.
 Deferred gains and losses on derivative
financial instruments.
46
Comprehensive Income
Most companies include a
report of comprehensive income
as part of the statement of
stockholders’ equity.
Earnings, Net Income, and
Comprehensive Income
Revenue
Expenses
Operating Income
Gains
Losses
Earnings
Cumulative Accounting Adjustment
Net Income
Unrecognized Holding Gains
Unrecognized Foreign Exchange Changes
Comprehensive Income
$100
80
$ 20
3
(8)
$ 15
(2)
$ 13
2
1
$ 16
47
48
The End