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The Income Statement and
Statement of Cash Flows
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

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An income statement for a hypothetical manufacturing company that you can refer to as we proceed through the chapter.

Income from Continuing Operations
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Revenues
Inflows of resources resulting from providing goods or services to customers.
Expenses
Outflows of resources incurred in generating revenues.
Gains and
Losses
Increases or decreases in equity from peripheral or incidental transactions of an entity.
Income Tax
Expense
Because of its importance and size, income tax expense is a separate item.

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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

Income Statement (Single-Step)
Proper Heading
Revenues
& Gains
Expenses
& Losses
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Income Statement (Multiple-Step)
Proper
Heading
Gross
Profit
Operating
Expenses
Nonoperating
Items

U. S. GAAP vs. IFRS
There are more similarities than differences between income statements prepared according to U.S. GAAP and those prepared applying IFRS.
Some differences are highlighted below.
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• Has no minimum requirements.
SEC requires that expenses be classified by function.
• “Bottom line” called net income or net loss.
• Report extraordinary items separately.
• Specifies certain minimum information to be reported on the face of the income statement.
• Allows expenses classified by function or natural description.
• “Bottom line” called profit or loss.
• Prohibits reporting extraordinary items.

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Earnings Quality
Earnings quality refers to the ability of reported earnings to predict a company’s future earnings.
Transitory Earnings versus
Permanent Earnings

Manipulating Income and
Income Smoothing
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“Most executives prefer to report earnings that follow a smooth, regular, upward path.”
~Ford S. Worthy, “Manipulating Profits: How It’s Done”, Fortune
Two ways to manipulate income:
1. Income shifting
2. Income statement classification

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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.

Nonoperating Income and
Earnings Quality
Gains and losses generated from the sale of investments often can significantly inflate or deflate current earnings.
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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?

Separately Reported Items
Reported separately, net of taxes:
Discontinued operations
Extraordinary items
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A third separately reported item, the cumulative effect of a change in accounting principle, might be included for certain mandated changes in accounting principles.

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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 tax effect.

Reporting Discontinued Operations
The FASB and IASB worked together to develop a common definition of discontinued operations and a common set of disclosures for disposals of components of an entity.
A “component” of an entity for this purpose is defined as either:
1. An operating segment that has either been disposed of or is classified as “held for sale”; or
2. A business that meets the criteria to be classified as held for sale on acquisition.
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Reporting 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.

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Extraordinary Items
An extraordinary item is a material event or transaction that is both:
1.
Unusual in nature, and
2.
Infrequent in occurrence
Extraordinary items are reported net of related taxes

U. S. GAAP vs. IFRS
The scarcity of extraordinary gains and losses reported in corporate income statements and the desire to converge
U.S. and international accounting standards could guide the FASB to the elimination of the extraordinary item classification.
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• Report extraordinary items separately in the income statement.
• Prohibits reporting extraordinary items in the income statement or notes.

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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.

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Accounting Changes
Type of Accounting
Change
Change in Accounting
Principle
Change in Accounting
Estimate
Change in Reporting
Entity
Definition
Change from one GAAP method to another GAAP method
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 Accounting Principle
• Occurs when changing from one GAAP method to another GAAP method, f or example, a change from LIFO to FIFO
• GAAP requires that most voluntary accounting changes be accounted for retrospectively by revising prior years’ financial statements.
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• For mandated changes in accounting principles, the FASB often allows companies to choose to account for the change retrospectively or as a separately reported item below extraordinary items.

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Change in Depreciation, Amortization, or Depletion Method
A change in depreciation, amortization, or depletion method is treated the same as a change in accounting estimate .

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Change in Accounting Estimate
Revision of a previous accounting estimate
Use new estimate in current and future periods
Includes changes in depreciation, amortization, and depletion methods

Change in Reporting Entity
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The prior-period financial statements that are presented for comparative purposes should be restated to appear as if the new entity existed in those periods.
When one company acquires another one, the financial statements of the acquirer include the acquiree as of the date of acquisition , and the acquirer’s prior-period financial statements that are presented for comparative purposes are not restated .

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Correction of Accounting Errors
Errors occur when transactions are either recorded incorrectly or not recorded at all.
Errors
Discovered in
Same Year
Reverse original erroneous journal entry and record the appropriate journal entry.
Material Errors
Discovered in
Subsequent Year
Record a prior period adjustment to the beginning retained earnings balance in a statement of shareholders’ equity.
Previous years’ financial statements that are incorrect as a result of the error are retrospectively restated to reflect the correction.

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 Diluted EPS
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Net income less preferred dividends
Weighted-average number of common shares outstanding for the period
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.

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Earnings per Share Disclosure
Report EPS data separately for:
1. Income or Loss from Continuing
Operations
2. Separately Reported Items a) discontinued operations b) extraordinary Items
3. Net Income or Loss

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Comprehensive Income
An expanded version of income that includes four types of gains and losses that traditionally have not been included in income statements.

Other Comprehensive Income
Comprehensive income includes traditional net income as well as four additional gains and losses that change shareholders’ equity.
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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).

U. S. GAAP vs. IFRS
As part of a joint project with the FASB, the International
Accounting Standards Board (IASB) in 2007 issued a new version of IAS No. 146 that revised the standard to bring international reporting of comprehensive income largely in line with U.S. standards.
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• Includes four possible Other
Comprehensive Income items.
• Includes same four.
• Includes a fifth possible item, changes in revaluation surplus, from the optional revaluation of property, plant, and equipment and intangible assets.

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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.

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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.

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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

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Direct and Indirect Methods of
Reporting
Two Formats for Reporting Operating Activities
Direct Method
Reports the cash effects of each operating activity
Indirect Method
Starts with accrual net income and converts to cash basis

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Direct Method
Under the direct method, the cash effect of each operating activity is reported directly in the statement.

Indirect Method
By the indirect method, we arrive at net cash flow from operating activities indirectly by starting with reported net income and working backwards to convert that amount to a cash basis.
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Investing Activities



Inflows from: sale of long-lived assets used in the business.
sale of investment securities
(stocks and bonds).
collection of nontrade receivables.



Outflows for: purchase of long-lived assets used in the business.
purchase of investment securities (stocks and bonds).
loans to other entities.
+
_
Cash
Flows from
Investing
Activities

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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

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ALC’s Statement of Cash Flows

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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).

U. S. GAAP vs. IFRS
Like U.S. GAAP, international standards also require a statement of cash flows. Consistent with U.S. GAAP, cash flows are classified as operating, investing, or financing.
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•
Typical Classification of Cash Flows from
Interest and Dividends
• Operating Activities • Operating Activities
–
Dividends Received
– Interest Received
– Interest Paid
• Investing Activities
Financing Activities
– Dividends Paid
• Investing Activities
– Dividends Received
–
Interest Received
• Financing Activities
– Dividends Paid
–
Interest Paid

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U. S. GAAP vs. IFRS
The FASB and IASB are working together on a project,
Financial Statement Presentation, to establish a common standard for presenting information in the financial statements.

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