Chapter 11
The Income Statement & The
Statement of Stockholders’ Equity
Learning Objectives
 Analyze
a complex income statement
 Account for a corporation’s income tax
 Analyze a statement of stockholders’
equity
 Understand managers’ and auditors’
responsibilities for the financial
statements
Income Statement

Periodically Prepared to report Financial
Consequences of Activities Undertaken
– By Accounting Entity
– Within a Certain Period of Time

Profit
– More resources available at end-of-period then
beginning-of-period

Loss
– Consumed more resources by the end-of-period
then it generated
Income Statement



Summary of Revenues and
Expenses
For a Specific Period of Time
Grouped by Class
– Administrative




– Sales


Returns and Allowances
Discounts
– Cost of Goods Sold
– Gross Margin/Profit
– Operating Expenses

Selling Expenses
–
–
–
–
–
–
Salaries
Advertising
Travel
Telephone
Supplies
Depreciation


Salaries
Telephone
Legal & Professional
Supplies
Depreciation – Bldg & Equip
Misc.
– Net Income from Operations
– Other


–
–
–
–
–
Interest Expense
Interest Income
Discontinued Operations
Extraordinary Events
Cumulative Effect of Change
Net Income
Earnings Per Share
Accounting Principles
 Matching
 Revenue
Realization
Income Statement - Continuing
Operations
Allied Electronics Corporation
Income Statement
Year Ended December 31, 20x5
Sales revenue
Cost of goods sold
Gross margin
Operating expenses
Operating income
$500,000
–240,000
$260,000
181,000
$ 79,000
Income Statement - Continuing
Operations
Operating income
Other gains (losses):
Loss on restructuring operations
Gain on sale of machinery
Income from continuing operations
before income tax
Income tax expense
Income from continuing operations
$79,000
( 8,000)
19,000
$90,000
36,000
$54,000
Income Statement - Special Items
Discontinued operations: $35,000,
less income tax of $14,000
Income before extraordinary items
and cumulative effect of change
in depreciation method
Extraordinary flood loss, $20,000,
less income tax savings of $8,000
Cumulative effect of change in
depreciation method, $10,000,
less income tax of $4,000
Net income
21,000
$75,000
(12,000)
6,000
$69,000
Income from Continuing
Operations
 A measure
of the part of the business
expected to be ongoing.
 Used to predict future income.
Predicting Future Profits
Estimated value of
Common Stock
=
If estimated value
of the company:
Exceeds
Equals
Is less than
Estimated annual
income in the future
Investment
capitalization rate
Decision
Current market
Value of the
Company
Buy the stock
Hold the stock
Sell the stock
Estimated Value of Common Stock
Operating Income
Income from Continuting Opeations
Market Value
Common Shares Outstanding
Market Price per share
Cap Rate Est Value Mke Value
79,000
0.12 658,333
513,000
54,000
0.12 450,000
513,000
108,000
4.75
513,000
Continuing Operations
 The
company restructured operations at
a loss of $8,000.
 Report as “Other” item – part of
continuing operations, but falls outside
of main business endeavor
Other Income Statement Items
Discontinued Operations
 Extraordinary Gains and Losses
(Extraordinary Items)

– Must be both infrequent

seldom happening or occurring
– and Unusual


not ordinarily encountered
Cumulative Effect of a Change in Accounting
Method
Discontinued Operations
 Segment
company
– Sold or
– Closed
– identifiable division of a
Extraordinary Items

Unusual for the company and infrequent
– Losses due to natural disasters
– Expropriations
 the action of the state in taking or modifying
the property rights of an individual in the
exercise of its sovereignty

An Exception
– Material gains/losses from extinguishment of debt
(to be reported as extraordinary item)
Cumulative Effect of a Change in
Accounting Principle
From double-declining-balance (DBB) to
straight-line depreciation
 From first-in, first-out (FIFO) to weightedaverage cost for inventory
 Report in a special section of the income
statement after extraordinary items

Earnings Per Share
Earnings per share =
Net Income - Preferred dividends
Average number of shares of
common outstanding
• Earnings per share is disclosed separately
for:
–
–
–
–
continuing operations
discontinued operations (do not subtract pfd)
Extraordinary items (don not subtract pfd)
Cumulative effect of change in accounting
method (do not subtract pfd)
Income Statement - Earnings per
Share
Earnings per share of common stock
(20,000 shares outstanding):
Income from continuous operations
(54000)/20000
Income from discontinued operations
(21000/20000)
Income before extraordinary item
and cumulative effect of change
in depreciation method
(75000/20000)
Extraordinary loss
(12000/20000)
Cumulative effect of change in
depreciation method
(6000/20000)
Net income
(69000/20000)
$2.70
1.05
$3.75
(0.60)
0.30
$3.45
Earnings Per Share
 Effect
of preferred stock
– preferred dividends must be paid before
distributions of earnings to common
stockholders.
 Dilution
– Convertible items could result in diluted
eps.
– Diluted EPS is disclosed on the income
statement.
Comprehensive Income
 Change
in total stockholders’ equity
from all sources other than from the
owners of the business.
– Unrealized gains (losses) on available-forsale investments
– Foreign-currency translation adjustments
Corporate Income Taxes
• Must measure
– Income tax expense
– Income tax payable
Income
tax
expense
Income before income
=
tax (from the
X
income statement)
Income
Tax Rate
Income
tax
payable
Taxable income from
the income tax return
filed with the IRS
Income
Tax Rate
=
X
Corporate Income Taxes
 Difference
between income tax expense
and income tax payable is a deferred
tax liability or deferred tax asset.
Accounting for Corporate
Income Taxes
Suppose for 20x5, Nike, Inc., has pretax
accounting income of $900 million on the
income statement.
 Taxable income is $800 million on the
company’s income tax return.
 The tax rate is 40%.

Accounting for Corporate
Income Taxes
General Journal
Date
Accounts and Explanations
PR
Dec 31 Income Tax Expense ($900 x .40)
Income Tax Payable ($800 x .40)
Deferred Tax Liability
Recorded income tax for the year
©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Debit
Credit
360
320
40
Accounting for Corporate
Income Taxes
Income statement
Income before income tax
Income tax expense
Net income
Balance sheet
Current Liabilities:
Income tax payable
Long-term liabilities:
Deferred tax liability
Total
$900
360
$540
$320
40*
$360
*Assumes beginning tax liability was zero.
Retained Earnings
 Prior
period adjustments
– corrections of errors that occurred in prior
periods.
 Since
the temporary accounts have
been closed to retained earnings, errors
from prior periods must be made to
retained earnings.
Reporting a Prior-Period
Adjustment
CNN Corporation
Statement of Retained Earnings
Year Ended December 31, 2005
Retained Earnings, Dec. 31, 2004 (original)
Prior-period adjustment – debit to correct error
in recording income tax expense of 2004
Retained earnings, Dec. 31, 2004, adjusted
Net income for 2005
Total
Deduct: Dividends for 2005
Retained earnings balance, Dec. 31, 2005
©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
$390,000
( 10,000)
$380,000
114,000
$494,000
( 41,000)
$453,000
Restrictions on Retained Earnings
Dividends and purchases of treasury stock
require payments by the corporation to its
stockholders
 Creditors may restrict a corporation’s dividend
payments and treasury stock purchases
 Companies report any retained earnings
restrictions in notes to the financial
statements

Statement of Stockholders’ Equity
Reports all changes in equity for the period.
 Issuance of stock
 Net income
 Cash dividends
 Stock dividends
 Treasury stock transactions
 Accumulated other comprehensive income

Statement of Stockholders’ Equity
Balance, Dec 31, 20X4
Issuance of stock
Net Income
Cash Dividends
Stock dividends – 8%
Purchase of Treasury Stock
Sale of Treasury Stock
Unrealized gain on investments
Foreign-currency
translation adjustment
Balance, Dec 31, 20X5
Common
Stock
$1 Par
$80,000
20,000
8,000
Additional
Paid-in
Capital
$160,000
65,000
26,000
Retained
Earnings
$130,000
69,000
(21,000)
(34,0000
(9,000)
4,000
7,000
$108,000
$258,000
Treasury
Stock
$(25,000)
$144,000
$(30,000)
Accumulated Other
Comprehensive Income
Unrealized
ForeignTotal
Gain
Currency Stockholders’
(loss) on
Translation
Equity
Investments
Adjustment
$6,000
$(10,000)
$341,000
85,000
69,000
(21,000)
-0(9,000)
11,000
1,000
1,000
3,000
3,000
$7,000
$ (7,000)
$480,000
Responsibility for the
Financial Statements
 Management
– issues a statement of responsibility with
financial statements
– declares responsibility for financial
statements and states that they conform to
GAAP
Auditor Report
Typically contains three paragraphs:
 Identifies the audited financial statements
 Describes how the audit was performed
 States the auditor’s opinion -financial
statements conform to GAAP and people
can rely on them for decision making
Auditor Report

Unqualified (Clean)
– the financial statements presented are free of material
misstatements and are in accordance with GAAP

Qualified
– the financial statements are fairly presented with a certain
exception which is otherwise misstated

Adverse
– the information contained is materially incorrect, unreliable, and
inaccurate in order to assess the auditee’s financial position and
results of operations

Disclaimer
– the auditor could not form, and consequently refuses to present,
an opinion on the financial statements