Chapter 4
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Chapter 4: Income Statement and Related Information
(REMEMBER: ALWAYS put headings on your financial statements, especially during the
EXAMS. Points are subtracted if the financial statements do not list the company name,
financial statement, date/time period. Also, ALWAYS date your journal entries.)
The purpose of this chapter is to examine the different types of revenues, expenses, gains, and
losses that affect the income statement and related information.
1) Income Statement: Report that measures the success of enterprise operations for a given
period of time. Provides investors and creditors with info that helps them predict the
amounts, timing, and uncertainty of future cash flows. (Objective #2 in our Basic Objectives
from Chapters 1 and 2.)
a Usefulness of the Income Statement: Income information is useful for:
i)
ii)
iii) Information about the various components of income – revenues, expenses, gains, and
losses – is helpful for assessing the likelihood that particular cash flows will continue
in the future.
b Limitations of the Income Statement: Net Income is an _________________ that
reflects assumptions made. Users should be aware of its limitations.
i) Items that cannot be measured reliably are not reported in the income statement. For
example:
(1)
(2)
ii)
iii)
c
Quality of Earnings: If managers are focused on meeting financial targets, such as
analysts’ forecasts to the detriment of good business practices, the quality of earnings and
the quality of financial reporting will erode.
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Earnings management:
It has a negative effect on earnings quality if it distorts the information that makes the
current year (1) misrepresentative of a company’s true state and (2) less useful for
predicting future earnings and cash flow.
2) Format of the Income Statement:
Transaction approach: focuses on the income-related activities that have occurred during
the period. That is, net income results from revenue, expense, gain, and loss transactions.
(Capital maintenance approach is the most common alternative. Here, income for the
period is determined based on change in equity, after adjusting for investments by owners or
dividends. However, the components of income are not evident in the capital maintenance
approach.)
a
Elements of the Income Statement:
i) Revenues:
ii) Expenses:
iii) Gains:
iv) Losses:
v) Gains and Losses:
Some examples:
b Single-Step Income Statement: LN: Aggregate Data.
i) Just two groupings exist: _________________________________________
The single step is subtracting ______________________________________.
Sometimes income tax is reported as the last item before net income (to show its
relationship to income before income tax.) Example on page 130.
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ii) Example Format:
SINGLE STEP FORM:
Company Name
Income Statement
For the Year Ended 12/31/xx
Revenues and Gains:
Net Sales
Other Revenue (e.g., Interest, Dividend revenue, Rent)
Total Revenues and Gains:
Expenses and Losses:
Cost of goods sold
Selling expenses
General and Administrative expenses
Depreciation expense
Interest expense
xx
xx
xx
xx
xx
xx
xx
xx
Total Expense and Losses
xx
Income from Continuing Operations
xx
THE REST OF THIS INCOME STATEMENT FOLLOWS THE SAME
APPROACH AS THE MULTI-STEP INCOME STATEMENT.
iii) Primary Advantage of Single Step IS: The presentation is simple and no
implication exists about the importance of any one type of revenue or expense item.
c
Multiple-Step Income Statement: example on page 132.
i) Further Classifications Included:
(1) Separate operating and non-operating company activities presented. For example,
“Income from Operations” is presented and then “Other Revenues and Gains” and
“Other Expenses and Losses” are presented.
(2) Expenses are classified by functions (e.g., COGS, selling, and administration.)
ii) Relationships Recognized:
(1) Recognizes Operating transactions separately from non-operating transactions.
(2) Matches Costs and expenses with related revenue.
(3) Highlights intermediate components of income useful for computation of ratios
used to assess enterprise performance.
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iii) Intermediate Components of the Income Statement:
(1) Possible Sections/Subsections of Multi-Step Income Statement (page 129)
(a) Operating Section:
(i) Sales or Revenue Section: Includes sales, discounts, allowances, returns,
and other related info.
(ii) Cost of Goods Sold Section.
(iii)Selling Expenses.
(iv) Administrative or General Expenses.
(b) Non-operating Section.
(i) Other Revenues and Gains.
(ii) Other Expenses and Losses.
(c) Income Tax.
(d) Discontinued Operations.
(e) Extraordinary Items.
(f) Earnings Per Share.
(2) To arrive at net income on the multi-step income statement, three subtotals are
presented:
(a)
(b)
(c)
Disclosing income from operations highlights the difference between regular
and irregular or incidental activities. Irregular or incidental revenues are
disclosed elsewhere in the income statement.
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iv) Example Format: MULTI-STEP FORM: (Be able to do this on your own.)
Company Name
Income Statement
For the Year Ended 12/31/xx
Sales Revenue
Cost of Goods Sold
Operating Expenses
Selling expenses
Sales salaries and commissions
Advertising expense
Postage and stationery
Telephone and Internet expense
General and Administrative expenses
Officers’ salaries
Office salaries
Depreciation expense
Miscellaneous office expenses
Income from operations
Other Revenues and Gains
Rental Revenue
Other Expenses and Losses
Income from continuing operations before income tax
Income tax
Income from continuing operations
Discontinued Operations
Income before extraordinary items
of accounting change
Extraordinary items
Net Income
Earnings per common share
Note: You will not always have all of these sections. For example, if there are no DE items (discontinued ops,
extraordinary items), after other expenses and losses, you would have Income before income tax, income tax, net
income. Also, the phrase “Income from continuing operating” is used only when gains or losses on
discontinued operations occurs. Otherwise, “Income from Operations”.
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d Condensed Income Statements:
Include only the totals of expense groups in the income statement and prepare
supplementary schedules to support the total. Page 133 shows a condensed version of the
more detailed multiple-step statement presented on page 132. The condensed version is
more commonly found in practice. (Notice the reference to “see Note D” in Illustration
4-3 on page 133. This refers to the supporting schedule for selling expenses shown in
Illustration 4-4 on page 134.)
Knowing how much detail to include in the Income Statement always presents a problem.
We want simple, summarized statements that lead readers to important factors. However,
we want to disclose results of all activities. Certain basic elements are always included
but they can be presented in various formants.
3) Reporting Irregular Items: Income measurement follows an all-inclusive approach. In
other words, most items, even irregular ones, are recorded in income. Prior period
adjustments (i.e., errors in prior years’ income measurement) are NOT included in income.
Because these items have affected earnings already reported in a prior period, they are not
included in current income but recorded as adjustments to retained earnings.
The accounting profession currently uses a modified all-inclusive concept and requires
application of this approach in practice. Irregular items are required to be highlighted so that
the reader of financial statements can better determine the long-run earnings power of the
enterprise. The items fall into six general categories (p136):
Above the Line:
(1)
(2)
(3)
(4)
Below the Line:
(5)
(6)
Where “Line” = “Income from continuing operations”.
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a
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Discontinued Operations:
i) Occurs when
(1)
(2)
ii) Segment Disposal: a segment is one which represents a:
(1)
(2)
iii) Disposals of assets that do not qualify as disposals of a segment of a business include
the following:
(1) Disposal of part of a line of business.
(2) Shifting production or marketing activities for a particular line of business from
one location to another.
(3) Phasing out of a product line or class of service.
iv) Important Dates:
(1) Measurement Date:
(2) Disposal Date:
(3) Phase-Out Period:
v) Generally reported in a separate income statement category for the gain or loss from
disposal of a component of a business.
vi) The results of operations of a component that has been or will be disposed of are also
reported separately from continuing operations. The effects of discontinued
operations are shown net of tax as a separate category, after continuing operations
but before extraordinary items. (See Illustration 4-6 on page 136. Also, see
sample format for Multi-Step Income Statement given above.)
vii) The phrase “Income from continuing operations” is used only when gains or losses on
discontinued operations occur.
viii) Form:
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Note:
(1)
(2)
ix) Example 1: Measurement date and disposal date are in the same period. (Recognize
all gains and losses.)
Ball Corp. decided on June 1, 2000 to dispose of a segment. From January 1 to June
1, the segment had income of $50,000. Ball sold the segment on October 1, 2000 for
a loss of $30,000. Income during the phase-out period was $10,000. The tax rate is
40%.
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x) Example 2:
Measurement date is October 1, 2000. Disposal date is May 1, 2001.
Realized
Income/Loss
on
Operations
[1]
10/1 to 12/31
1.
2.
3.
4.
5.
Estimate
Income/Loss
on
Operations
[2]
1/1/01 to
5/1/01
Estimated
Gain/Loss
on
Disposal
[3]
5/1/01
What do we
report in 2000?
What do
we report
in 2001?
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b Extraordinary Items:
i) Nonrecurring material items that differ significantly from the entity’s typical
business activities.
ii) Shown net of taxes on income statement in a separate section. (See Illustration 4-7 on
page 138 and format for Multi-Step income statement given above.)
iii) See page 137 for list of gains/losses that are NOT extraordinary items. List includes
such gains/losses as gains/losses on disposal of a component of an entity
and effects of a strike, including those against competitors and major suppliers.
These are NOT extraordinary items.
iv) Only rarely does an event/transaction clearly meet the criteria for an extraordinary
item. The environment in which the entity operates must also be considered.
Examples:
(1) Extraordinary items:
(2) NOT Extraordinary items:
v) Considerable judgment must be used when determining whether an item is
extraordinary.
c
Changes in Accounting Principle:
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i) Include as a retrospective adjustment to financial statements. Recast the prior years’
statement on basis consistent with newly adopted principle. Record cumulative effect
of change for prior periods as an adjustment to beginning retained earnings of earliest
year presented.
ii) Disclose change in the footnotes. Changes violate the ______________ concept;
however, the change should be justified. Retrospective approach preserves
________________ across years.
iii) See example on pages 140-141 (Illustrations 4-10 and 4-11.)
d Unusual Gains and Losses:
Restructuring charge:
e
Changes in Estimates:
i) Occasionally a company will need to change an accounting estimate.
ii)
iii)
iv) Examples:
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f
Correction of Errors (Prior Period Adjustments):
i) Occasionally companies make errors when reporting items such as revenue, stock
options, and allowance accounts.
ii) Record correcting entries in accounts and treat as prior period adjustments. In other
words, adjust beginning balance of retained earnings. Record in year discovered.
iii) See example on page 142.
g Summary of Irregular Items: Know Illustration 4-12 on page 142.
4) Special Reporting Issues:
a Intraperiod Tax Allocation: Allocation of tax within a period (i.e., let the tax follow the
income.) In other words, relate tax expense for a given year to the specific items on the
income statement. Used for: (1) income from continuing operations, (2) discontinued
operations, and (3) extraordinary items. A separate tax effect is associated with each
irregular item.
i) Extraordinary Gains: See example (Illustration 4-13) on page 143.
ii) Extraordinary Losses: See example (Illustration 4-14) on page 144.
b Earnings Per Share:
The numerator is also referred to as income available to common stockholders.
c
i) Required to be disclosed in the income statement.
ii) If the company has a discontinued operation, extraordinary item, or a change in
accounting principle, per share amounts must be reported for these line items either
on the income statement or in the notes to the financial statements. (See Illustration
4-17 on page 145.)
Retained Earnings Statement:
i) Net income increases R/E.
ii) Net loss decreases R/E.
iii) Cash and Stock Dividends decrease R/E.
iv) Prior Period Adjustments and Changes in Accounting Principle:
(1)
(2)
(3)
(4)
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v) Example Format:
Balance, January 1
Company Name
Statement of Retained Earnings
For the Year Ended 12/31/xx
xx
Add: Net Income
Less: Dividends
Balance, December 31
xx
xx
xx
vi) Restrictions of Retained Earnings:
(1) Appropriated (Restricted) Retained Earnings:
(2) Unappropriated (Unrestricted) Retained Earnings:
(3)
d Comprehensive Income:
i) Comprehensive Income Defined:
(1) Keeps track of items that bypass the income statement.
(2) Includes all changes in equity during a period except those resulting from
investments by owners and distributions to owners. It includes all revenues and
gains, expenses and losses reported in net income, and in addition it includes
gains and losses that bypass net income but affect stockholders’ equity. These
items are referred to as other comprehensive income.
(3) Other Comprehensive Income = foreign currency translation gain/loss +
unrealized gain/loss on AFS securities + excess of additional pension liability
over unamortized prior service cost + changes in market value of a futures
contract that is a hedge of an asset reported at fair value.
(4) Earnings per share information related to CI is NOT required.
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ii) Comprehensive Income Presentation: Presented in one of three ways.
(1) Second Income Statement: See Illustration 4-19 on page 148.
(2) Combined Income Statement:
(3) Statement of Stockholders’ Equity: See Illustration 4-20 on page 148.
Balance Sheet Presentation: See Illustration 4-21 on page149.