The Income Statement
and the Statement of
Stockholders’ Equity
Chapter 11
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Learning Objective 1
Analyze a complex income
statement.
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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
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
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
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
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
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Income Statement - Earnings per
Share
Earnings per share of common stock
(20,000 shares outstanding):
Income from continuous operations
Income from discontinued operations
Income before extraordinary item
and cumulative effect of change
in depreciation method
Extraordinary loss
Cumulative effect of change in
depreciation method
Net income
$2.70
1.05
$3.75
(0.60)
0.30
$3.45
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
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
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Continuing Operations
Investment capitalization rate –
used to estimate the value of an
investment in the capital stock
of another company
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Continuing Operations
Assume an interest rate (i) of 12%
to valuate Allied.
Estimated value of Allied Electronics
common stock =
Estimated annual income in the future
÷ Investment capitalization rate
= $54,000 ÷ 0.12 = $450,000
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Continuing Operations
Current market
# of shares
value of the = of common stock ×
company
outstanding
$513,000
=
108,000
©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
×
Current
market price
per share
$4.75
Continuing Operations:
Investment Decision
Decision Rule:
Estimated value > market value? BUY
Estimated value = market value? HOLD
Estimated value < market value? SELL
In the Allied Electronics case:
Estimated
Current
value of the
market
<
Sell the stock
company
value
$450,000
$513,000
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Continuing Operations:
Investment Decision
Estimated value of
one share of common stock
=
Estimated annual earnings per share
÷
Investment capitalization rate
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Irregular Items
1. Discontinued operations
2. Extraordinary items
3. Cumulative effect of a change
in accounting principle
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Discontinued Operations
Segment – identifiable division
of a company
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Extraordinary Items
 Unusual for the company and
infrequent
 Losses
due to natural disasters
 Expropriations
 Exception
 Material gains/losses from
extinguishment of debt (to be
reported as extraordinary item)
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Cumulative Effect of a Change
in Accounting Principle
 From double-declining-balance
(DBB) to straight-line depreciation
 From first-in, first-out (FIFO) to
weighted-average cost for inventory
 Report in a special section of the
income statement after
extraordinary items
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Earnings per Share
of Common Stock
(Net Income – Preferred Dividends)
÷
Average Number of
Common Shares Outstanding
=
Earnings per Share
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Earnings per Share
of Common Stock
Required to be disclosed on the
income statement for all major
sections
Earnings per share is subject to
dilution (reduction), if issue of
additional shares is possible in
the future
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Comprehensive Income
 Change in total stockholders’ equity
from all sources other than from
owners of the business
 Includes net income plus
unrealized gains (losses) on
available-for-sale investments and
foreign-currency translation
adjustments
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Statement of
Comprehensive Income
Net income
Other comprehensive income:
Unrealized gain on investment
Less income tax (40%)
Foreign-currency translation
adjustment (loss)
Less income tax (40%)
Comprehensive income
$69,000
$ 6,500
2,600
$(9,000)
3,600
©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
3,900
( 5,400)
$67,500
Learning Objective 2
Account for a corporation’s
income tax.
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Accounting for Corporate
Income Taxes
Income tax expense – expense
on income statement
Income tax payable – liability on
balance sheet
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Accounting for Corporate
Income Taxes
In general, income tax expense and income
tax payable can be computed as follows:
Income
tax
expense
Income
tax
payable
=
Income before
income tax
(from the
income
statement)
=
Taxable
income (from
the income tax
return filed
with the IRS)
×
Income
tax
rate
×
Income
tax
rate
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
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%.
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
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
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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.
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Prior-Period Adjustments
Corrections to the beginning
balance of Retained Earnings
for errors of an earlier period
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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
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$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
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Learning Objective 3
Analyze a statement of
stockholders’ equity.
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Analyzing the Statement of
Stockholder’s Equity
Common Additional
Stock, $1
Paid-in
Retained Treasury
par
Capital
Earnings
Stock
Balance, Dec. 31, 20x4
$80,000 $160,000 $130,000
($25,000)
Issuance of stock
20,000
65,000
Net income
69,000
Cash dividends
(21,000)
Stock dividend – 8%
8,000
26,000
(34,000)
Purchase of treasury stock
(9,000)
Sale of treasury stock
7,000
4,000
Unrealized gain on
investments
Foreign-currency
translation adjustment
Balance, Dec. 31, 20x5
$ 108,000 $ 258,000 $ 144,000 $ (30,000)
©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Analyzing the Statement of
Stockholder’s Equity
Accumulated Other Comprehensive
Income
Balance, Dec. 31, 20x4
Issuance of stock
Net income
Cash dividends
Stock dividend – 8%
Purchase of treasury stock
Sale of treasury stock
Unrealized gain on
investments
Foreign-currency
translation adjustment
Balance, Dec. 31, 20x5
Unrealized Gain
(Loss) on
Investments
$6,000
Foreign-Currency
Total
Translation
Stockholders’
Adjustment
Equity
($10,000)
$341,000
85,000
69,000
(21,000)
-0(9,000)
11,000
1,000
$7,000
1,000
3,000
($7,000)
3,000
$480,000
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Learning Objective 4
Understand managers’ and
auditors’ responsibilities for the
financial statements.
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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
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
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
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Auditor Report
Unqualified (Clean)
Qualified
Adverse
Disclaimer
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End of Chapter 11
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren