The Income Statement and Statement of Cash Flows
THE INCOME STATEMENT
The income statement reports the business entities’ net income or loss for a specific period of
time (the accounting period). It is a summary of the activities of the business entities economic
activities.
COMPREHENSIVE INCOME
Some economic activities are not included in net income (loss) and therefore are not included in
the change to retained earnings at the end of the accounting period. Comprehensive income is
defined as the total chance in equity as a result of transactions during the period except those
between the owners and the enterprise. Comprehensive income includes net income and any
other transactions with non-owners that change the equity section of the balance sheet.
The transactions that are not part of net income are called other comprehensive income and
include unrealized holding gains/losses on investments, foreign currency translation adjustments
and several other types of transactions that will be discussed in Intermediate Accounting II.
As we have moved closer and closer to fair value accounting as opposed to historical cost the
FASB has allowed business entities to record changes in the net assets as charge or credit to the
equity section of the balance sheet. This means that some income or loss items have not made it
to the income statement. To compensate for this lack of information the FASB now requires that
comprehensive income be reported as part of the financial reporting process. This can be
accomplished in three different ways.
1. Separate statement: Comprehensive Income Statement
2. Combined with the regular income statement: Combined Statement of Comprehensive
Income, or
3. Incorporated into a Statement of Stockholders’ Equity.
INCOME FROM CONTINUING OPERATIONS
The income statement reflects the transactions that have taken place during the current
accounting period. There are four elements of the income statement:
(1) Revenues-increases in assets or decreases in liabilities as a result of selling products or
services
(2) Expenses-use of assets or incurrence of debt as a result of delivering the products or
services
(3) Gains-increases in net assets as a result of transactions that are not part of the normal
business activities
(4) Losses-decreases in net assets as a result of transactions that are not part of the normal
business activities
Multi-Step Income Statements
The textbook talks about single-step and a multi-step income statement formats. We are
primarily interested in learning how to prepare multi-step income statements as they are the most
widely used in the business world. The multi-step income statement separates operating and
non-operating activities making it easier for financial statement users to differentiate operating
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The Income Statement and Statement of Cash Flows
income from other activities. In addition, expenses are grouped by function so that comparisons
can be made between years.
The following reflects the basic framework of a multi-step income statement.
Sales revenue
Cost of goods sold
Gross profit
Operating expenses:
Selling expenses
Administrative expenses
Income from operations
Other revenue and gains
Other expenses and losses
Income before income tax
Income taxes
Net income
$
$
$
$
$
Earnings per share
$
$
$
$
$
$
$
$
INTERMEDIATE COMPONENTS OF THE INCOME STATEMENT
Depending on the transaction that took place during the current accounting period the following
sections of the income statement might be presented.
1. Operating Section
Sales and revenue
Cost of goods sold
Gross profit
Operating expenses
Selling expenses
Administrative expenses
Income from operations
2. Nonoperating Section
Other revenue and gains
Other expenses and losses
3. Income Tax
4. Discontinued Operations (net of tax)
5. Extraordinary Items (net of tax)
6. Earnings Per Share
Condensed Income Statements
Most large companies will prepare condensed income statements with appropriate footnotes
containing the details for those financial statement users who are interested. In this situation the
basic framework presented above would be presented in the body of the financial statements.
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The Income Statement and Statement of Cash Flows
SEPARATELY REPORTED ITEMS
The textbook discusses the reporting of separately items and lumps together those that are
reported below the line and those reported above the line. We are going to separate the
discussion into two categories of separately reported items.
BELOW THE LINE SEPARATELY REPORTED ITEMS
The line we are referring to is called income from continuing operations. In the previous lesson
we prepared an income statement that ended with net income. If there are certain separately
reported, net income is renamed income from continuing operations and additional line items
follow--see Figure 1 item (3). All separately reported items below income from continuing
operations are reported net of the related income tax effect. Separately reported items below
the line are:
1. Discontinued operation: See Figure 1 item (4). This includes (a) gains or losses on
operations that are to be discontinued and (b) gains or losses on the disposition of the
discontinued operations.
2.
3. Extraordinary item: See Figure 1 item (5). These are material transactions that took
place during the accounting period that are:
a. Unusual in Nature, and
b. Infrequent in Occurrence.
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The Income Statement and Statement of Cash Flows
Figure 1 – Income Statement
Income Statement - Year 2002
(1)
(2)
(3)
(4)
(5)
Net sales
Cost of goods sold
Gross profit
Operating expenses
Administrative expenses
Income from operations
Other revenues and gains
Gain on sale of equipment
Other expenses and losses
Loss on sale of securities
Income from continuing operations before tax
Income taxes (30% rate)
Income from continuing operations
Discontinued operations:
Gain on disposal of division
Less: applicable income tax expense
Income before extraordinary item
Extraordinary item:
Major casualty loss
Less: applicable income tax benefit
Net income
$8,200,000
5,300,000
2,900,000
$1,320,000
298,000
1,618,000
1,282,000
58,000
(67,000)
1,273,000
(381,900)
891,100
112,000
(33,600)
(73,000)
21,900
78,400
(51,100)
$918,400
ABOVE THE LINE SEPARATELY REPORTED ITEMS
There are two types of transactions that do not qualify for below the line treatment. These are
reported gross because they are part of taxable income. The two items are:
1. Unusual gains and losses: See Figure 1 items 1 & 2. These are gains and losses that
might be unusual in nature or infrequent in occurrence but not both. If they are material
they are normally reported as a separate line item before income from continuing
operations as part of Other Revenues and Gains or Other Expenses and Losses.
ACCOUNTING CHANGES
Change in Accounting Principle
A change in accounting principle is a change from one acceptable accounting principle to
another acceptable accounting principle during the period. Such changes are accounted
for retrospectively, that is the financial statements are restated reflecting the change for
all accounting periods reported.
Change in estimates
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The Income Statement and Statement of Cash Flows
Estimates are used frequently in accounting. Changes in these estimates are incorporated
into the current and future periods but not reflected separately in the income statement.
Changes in estimates would be part of the current year calculation and would be reported
in current operating expenses. Changes in amortization, depreciation, depletion and bad
debt expenses are examples of such changes.
Change in Reporting Entity
In the event of a merger or acquisition reporting in the current period is on an entity that
did not exist in prior periods. The new entity is requires to restate all financial statements
presented for comparative purposes as if the entity existed in each of the prior periods.
CORRECTION OF ACCOUNTING ERRORS
On occasion a material error is made in the preparation of financial statements. If the error is
discovered at the next year end it is treated as a prior period adjustment. A prior period
adjustment is added to or subtracted from the beginning retained earnings in the statement of
retained earnings in order to obtain a restated correct beginning balance. If comparative
financial statements are prepared the error is corrected in the previous financial statements and
the prior period adjustment is made to the earliest beginning retained earnings.
INTRA-PERIOD TAX ALLOCATION
The procedure of allocating income taxes to income from continuing operations, discontinued
operations, extraordinary items, and changes in accounting principle is called intra-period tax
allocation. The purpose of this allocation is for the income tax to follow the income or loss of
the components of the income statement, i.e. relate the income tax to each major item on the
income statement.
EARNINGS PER SHARE
All publicly traded companies are required to report earnings per share (EPS). EPS is calculated
as the net income less preferred dividends divided by the weighted average number of shares of
common stock outstanding during the accounting period.
NET INCOME - PREFERRED DIVIDENDS DECLARED
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING
EPS is reported on the face of the income statement. If the company has one or more below the
line irregular items, the per share effect of each separately reported item must also be reported.
For example, per share information must be reported for each of the following items if the item is
included in the income statement
EPS
=
Earnings Per Share
• Income from continuing operations
• Income from discontinued operations-net of tax
• Loss on disposal of discontinued operations-net of tax
• Income before extraordinary item and cumulative effect
• Extraordinary item-net of tax
• Net income
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The Income Statement and Statement of Cash Flows
Statement of Retained Earnings
In complex business organizations the statement of retained earnings is prepared as a separate
statement. It presents the beginning balance, prior period adjustments (if any), the adjusted
beginning balance, net income, dividends, and the ending balance. In smaller companies, the
retained earnings statement can be combined with the income statement. The resulting statement
is called the statement of income and retained earnings.
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