Chapter 6
The Income Statement
and Measures of
Performance
Chapter 6--Learning Objectives
1. Explain the different concepts of
income, cash, economic, and
accrual-based income measures
Concepts of Income
$Cash Basis
$Economic
$Accrual Basis
Cash Basis Income
Income = Cash inflow - Cash outflow
Not reported as income under GAAP
Reported in Statement of Cash Flows as
net cash flow from operating activities
Economic Income
Based on concept of “well-offness”
Economic Income is the maximum
amount that can be distributed to
owners during the accounting period
and leave the business as well off at the
end of the accounting period as it was
at the beginning of the period
Economic Income



A Capital maintenance concept of income
Income is the change in “value” of the net
assets of the business during the accounting
period
Measurements of assets and liabilities would
be based on “fair value” at the balance sheet
date, i.e., the present value of expected future
cash flows
Accounting Income
Accrual Basis Income



Transactions based
The change in net assets is
measured utilizing historical
cost (with modifications)
A financial capital
maintenance concept of
income
Accrual Basis Income
Characteristics



Revenue recognized when earned
Expenses matched with revenue
Based on historical cost
Income =
Revenue + Gains
- Expenses - Losses
SFAC 1

Objectives Of Financial Reporting
 To
provide information
 Useful
in Investment & Credit Decisions
 Useful in Assessing Cash Flow
Prospects
 About Enterprise Resources, Claims to
Those Resources, & Changes in Them
SFAC 1: Enterprise
Performance & Earnings




The primary focus of financial reporting
Expectations about future performance
are commonly based on past
performance
Accrual based earnings provide a better
indication of performance than cash flows
Relate Benefits and Costs of Operations,
Events & Circumstances that affect the
Enterprise
Accrual Basis
Accounting Income


Consistent with the concept of
Financial Capital Maintenance
Income = the change in net assets
occurring during the period
excluding transactions with owners
Chapter 6--Learning Objectives
2. Demonstrate the format of the
income statement
Income Statement

Includes the following elements of
financial statements
 Revenues
 Expenses
 Gains
& Losses
Income Statement
Formats


Single Step
Multiple Step
Single Step
Revenues & Gains
minus Expenses & Losses
Including
Income Taxes
Single-step income
statement form
Revenues:
Sales revenue
Interest income
Dividend revenue
Gain on sale of equipment
Other income
Total revenue
$XXX
XXX
XXX
XXX
XXX
XXX
Single-step income
statement form
Expenses:
Cost of goods sold
Selling & administrative expense
Interest expense
Loss on sale of land
Other expense
Provision for income taxes
Total expenses
XXX
XXX
XXX
XXX
XXX
XXX
XXX
Multiple-step income
statement form
Sales revenue
$XXX
Cost of goods sold
XXX
Gross profit
XXX
Operating expenses:
Selling & administrative expense XXX
Other operating expenses
XXX
Operating expenses
XXX
Income from operations
XXX
Multiple-step income
statement form
Other revenue and gains:
Interest revenue
Gain on sale of equipment
Other expenses and losses:
Loss on sale of land
Other expenses
Other revenue (expense)
Income before taxes
Provision for income taxes
Net Income
XXX
XXX
XXX
XXX
XXX
XXX
XXX
XXX
Income statement form


Both single-step and multi-step
formats are acceptable
APB Opinion No. 30 requires special
presentation of:
Discontinued operations
Extraordinary items
Cumulative effects of changes in
accounting principles
Elements of the income statement
Sales and operating revenues
Revenues from sales less discounts,
returns and allowances
Cost of goods sold
Beginning inventory plus purchases (net
of returns & allowances but including
transportation) less ending inventory
Operating expenses
Normally classified as administrative
expenses and selling expenses
Elements of the income statement
Non-operating items
Revenues, expenses, gains and losses
outside the normal operations of the
business
Provision for income taxes
Includes federal, state and local income
taxes
Special reporting items
Discontinued operations, extraordinary
items and accounting changes
Chapter 6--Learning Objectives
3. Specify which circumstances qualify
as special reporting items, and
explain how to measure and report
those special items on the income
statement
Extraordinary Items
APB 30
Absent discontinued operations,
the following main captions should be
reported in the income statement if
extraordinary items are reported
Income before Extraordinary Item XXX
Extraordinary Item (less applicable
taxes of $____)
XXX
Net Income
XXX
Net sales
CGS
Gross profit
Operating expenses
Income from operations
Other…(non operating items)
XXX
XXX
XXX
XXX
XXX
XXX
Income before tax & extraordinary item XXX
Income tax
XXX
Income before extraordinary item
XXX
Extraordinary item (net of tax)
Net income
XXX
XXX
Extraordinary Items?
APB 30

Events and transactions that are
distinguished by their unusual
nature and infrequency of
occurrence
Unusual Nature



Abnormal
Significantly different from
ordinary and typical activities of
the entity
Beyond the control of
management
Unusual Nature

Primary consideration
 The environment in which
the entity operates
 Characteristics of the
industry
 Geographical location
 Extent of governmental
regulation
Infrequent



Not reasonably expected to recur
in the foreseeable future
Take into account the environment
in which the entity operates
Prior occurrence provides
evidence to assess the probability
of recurrence
Extraordinary Items
Examples

Results of a major casualty,
e.g.,
 Earthquake


Expropriation
Prohibition under a newly
enacted law or regulation
Items which are NEVER
considered to be extraordinary




Write-downs of receivables and
inventories
Foreign exchange gains and losses
Gains and losses from sale or
abandonment of property, plant and
equipment
Labor disturbances
Accounting Change
APB 20



Change in Accounting Principle
Change in Reporting Entity
Change in Estimate
Change in Accounting
Principle


Changing from one generally
accepted accounting principle
to another
Examples:
 Change
from LIFO to FIFO
 Change from SYD
Depreciation to Straight-line
Change in Reporting Entity


When a company has investments in
other entities over which it exercises
significant influence or control
Change
 how
the investment is reported in the
balance sheet and income statement

Example
 Change
from the equity method of
accounting to consolidation
Change in Estimate


Change in “good faith” estimate
Prompted by
 Environmental
changes
 Availability of new information

Examples
 Change
in estimate of useful life of
building
 Change in fair value of investments
in “trading securities”
Accounting Treatments
for Accounting Changes



Current
Retroactive
Prospective
Current Treatment



Report Cumulative Effect in
the Income Statement
Do not restate prior financial
statements
Report Pro-forma Effects for
 Income
before extraordinary
items
 Net Income
Cumulative effect in income statement
APB 30
Income from 0perations
Other…(non operating items)
Income before extraordinary item and
cumulative effect of accounting change
Extraordinary item (less taxes of $____)
Cumulative effect of accounting change
(less taxes of $_____)
Net income
XXX
XXX
XXX
XXX
XXX
XXX
When to apply Current
Treatment

Changes in Principle
 Exceptions
are treated
retroactively

Example
 Change
from Straight-line
Depreciation to Double
Declining Balance
Retroactive Treatment



Report cumulative effect as an
adjustment to the beginning
balance of Retained Earnings
Restate prior financial
statements
No need to report separate
Pro-formas
Retroactive treatment is required for






Changes from LIFO
Changes to or from full cost method in the
extractive industry
Changes to the equity method of accounting
for investments in stock
Changes in accounting for long-term
contracts
Changes from retirement/replacement
accounting to other depreciation methods
Changes associated with an IPO of stock
Discontinued operations: APB: 30
Income from continuing operations
before tax
XXX
Income tax expense
XXX
Income from continuing operations
XXX
Discontinued operations (less taxes)
XXX
Extraordinary Items (less taxes)
Cum effect of accounting change
(less taxes)
Net income
XXX
XXX
Discontinued Operations:
APB 30

Separately identifiable segment which
is being disposed of
 A major
class of business
 Separately identifiable assets,
liabilities, revenues, and expenses
Discontinued Operations
In the Income Statement

Two components
Income
(loss) from
operations
Gain (loss) from
disposal
Discontinued Segment
Income (Loss) from Operations


Disclosed when the decision to
discontinue was made after the
beginning of the year
Amount of income (loss) is
determined from the beginning of the
year to the date the decision is made
to discontinue a segment’s
operations (measurement date)
Gain (loss) from disposal of
segment assets


Gain (loss) during the phase-out
period
Phase-out period can extend to
subsequent accounting period
The Possibilities


Measurement Date & Disposal Date
occur in same accounting period
Measurement Date occurs in current
period, Disposal Date occurs in a
subsequent accounting period
Measurement Date & Disposal Date
in Same Period
Beginning
of year
Measurement
Date
A
Disposal
Date
B
Phase Out
Realized
Gain
(Loss)
Year
End
Disposal Date in Subsequent Period
Beginning Measurement
of year
Date
A
Disposal Year
End 2
Date
Year
End 1
B
Realized
Gain
(Loss)
C
Estimated
Gain
(Loss)
Disposal During a Subsequent
Period - Special Rules
1
A realized Loss on disposal
a
b
2
Increase by estimated loss
Decrease by estimated gain (but only to
zero)
A realized Gain on disposal
a
b
Decrease by estimated loss
Do not increase by estimated gain
Chapter 6--Learning Objectives
4. Specify which circumstances qualify
as prior-period adjustments, and
explain how to measure, account
for, and report those adjustments in
the financial statements
Prior period adjustments


SFAS No. 16 specifies three types:
1. Corrections of errors
2. Adjustments involving tax loss
carryforwards of purchased
subsidiaries
3. Others specified by the FASB
Our focus is on the first type
Prior period adjustments
Require Retroactive Treatment




Do not affect income in the year of
discovery
Are NOT reported on the income
statement
Adjustments are made directly to the
Retained Earnings account
Adjustments are reported on the
Retained Earnings statement
Prepare the statement of
retained earnings
Retained earnings, Jan. 1, 2000,
(as previously reported)
$900,000
Correction of error in depreciation
expense not charged in prior periods
(net of $7,000 tax)
( 15,000)
Retained earnings, Jan. 1, 2000,
(restated)
$885,000
Net income
110,000
Retained earnings, Dec 31, 2000 $995,000
Chapter 6--Learning Objectives
5. Illustrate the computations and
reporting requirements for earningsper-share presentations
EPS
EPS


What a share of common stock
earned during the accounting
period
Numerator = Income to Common
Stockholders
 Subtract

preferred dividends
Denominator = Weighted average
number of shares outstanding
Must report EPS for




Income from Continuing Operations
Discontinued Operations
Extraordinary Items
Net Income
Chapter 6--Learning Objectives
6. Understand corporate risk
and profitability analysis,
using the basic ratios and
categories of ratios
Profitability analysis
The most common measure is return on
assets (ROA) calculated as follows:
Net income + [(Interest expense) x (1 - Tax rate)]
Average total assets
Return on assets


Measures the return on the average
capital invested in assets during the
accounting period.
Since both lenders and stockholders
provide capital, ROA includes income
before interest and its associated tax
benefit.
Risk Analysis



ROA ignores the means by which
operations are financed.
Also, investors are interested in the
return to common stock
Hence, a frequent adjustment is to
calculate the return on equity (ROE),
sometimes called return on common
equity (ROCE)
Return on common equity
Return on assets
Less:
Return to creditors
Less:
Return to preferred shareholders
Equals: Return to common shareholders
or
Net income - preferred dividends
Average common equity