Chapter 4 Schedule
• 9/26
Income Measurement and Income
Statement Form pps. 153—166
• 10/01 Components of the Income Statement,
Comprehensive Income & Stockholders Equity pps.
167--187
• 10/03 no class
• 10/08 completion of chapter 4
• Required problems: 40, 41, 48, 51
• Exam 4 opens 10/08, closes 10/09
Learning Objectives—chapter 4
1. Define the concept of income.
2. Explain why an income measure is
important.
3. Explain how income is measured,
including the revenue recognition
and expense matching concepts.
4. Understand the format of an income
statement.
Learning Objectives (cont.)
5. Describe the specific components of
an income statement.
6. Compute comprehensive income and
prepare a statement of stockholders’
equity.
7. Construct simple forecasts of income
for future periods.
INCOME—FASB
CONCEPTUAL FRAMEWORK
• “information about earnings and its
components measured by accrual
accounting generally provides a better
indication of enterprise performance
than information about current cash
receipts and payments.”
What is Income?
• Income is a Return over and above the
investment
• Income is the amount an entity could
return to investors and still leave the
entity as “well-off” at the end of the
period as it was at the beginning
Income Determination
•
Financial Capital Maintenance
Concept states:
Net assets (ending)- Net assets (beginning)
= Income IF:
 No investments by owners or
distributions were made in the period.
•
Thus, the change in net assets could
be equal to income for the period.
Financial Capital Maintenance
Kreidler, Inc. had the following
assets and liabilities at the beginning
and at the end of a period.
Beginning
of Period
Total assets
Total liabilities
$510,000
End of
Period
$560,000
430,000
390,000
Income is $90,000
Net assets
(owners’ equity) $ 80,000
$170,000
Financial Capital Maintenance
If the owners invested $40,000 in
the business and received
dividends of $15,000, what would
be the income?
Net assets, end of period
$170,000
Net assets, beginning of period 80,000
Increase in net assets
$ 90,000
Deduct investment by owners (40,000)
Add dividends to owners
15,000
Income
$ 65,000
Why is Income measurement
important?
• Inherently important as a major
component of business and evaluation
of activities
• Helps assist in allocating resources to
the most efficient and effective use
• Used by creditors, investors, govt.
How is Income measured?
• The transaction
approach yields the
same net income
number as financial
capital maintenance
and provides means
of measuring cash
flows as well.
• Also known as the
matching method.
How is Income measured?
• Transaction approach focuses on
business events that affect financial
statement elements: revenues,
expenses, gains, losses
• Measures the net effect over time
Problems with Income
measurement
• At what point should we recognize a
revenue or gain
• When should an expense or loss be
matched
Revenue and Gain Recognition
•
•
Revenue is recognized when goods or
services have been provided and the
customer commits to payment.
Revenues & gains recognized when:
1. They are realized* or realizable*, and
2. They have been earned through substantial
completion of the activities involved in the
earnings process.
Realized means payment has been received
Relizable means we have received an asset
that is convertible to cash
Earlier Recognition
•
Situations where revenue can be
recognized earlier:
1. If a product will sell at an established
price which is practically ensured without
significant selling effort.
2. If a product or service is contracted for in
advance, revenue may be recognized as
production occurs
(percentage-of-completion or proportional performance
methods of revenue recognition.
Later Recognition
• If payment for products or services is
considered doubtful, revenues and
gains may be recognized as the cash
is received.
– Installment Sales method
– Cost Recovery method
• Point-of-sale method will generally be
followed for our problems unless
othewise indicated
Expenses and Loss Recognition
• Three categories for expense
recognition:
1. Direct Matching
2. Systematic and rational
allocation
3. Immediate recognition
Expenses and Loss Recognition
• Direct Matching- relating expenses to
specific revenues.
• Systematic and Rational Allocation- costs of
assets that benefit more than one period
are spread across periods in a systematic
and rational way. (depreciation)
• Immediate Recognition- expenses that do not
relate to specific revenues, but are incurred
to indirectly generate revenue or when
future benefits are highly uncertain. (admin
expenses)
Let’s Practice
• 4-1, 3, 4, 5
• Ex 22, 23, 24, 25
Form of the Income Statement
• Traditionally, income from continuing
operations is presented:
– In a single step form- all revenues and
gains are first on the statement.
– Multiple step form- divided into separate
sections and various subtotals are
reported that reflect different levels of
profitability.
Form of the Income Statement
Revenue
Costs and expenses:
Costs of sales
Selling and administrative
Interest expense
Other income/expense, net
Restructuring charge
Total costs and expenses
Income before income taxes
Income taxes
Net income
Single-Step
Income
Statement
$xxx
xxx
xxx
xxx
xxx
xxx
xxx
xx
xx
$ xx
Form of the Income Statement
Revenue
Costs of goods sold:
Beginning inventory
Net purchasesMultiple-Step
Cost of goods available for sale
Income
Less ending inventory
Statement
Gross profit on sales
Operating expenses:
Selling expenses
General expenses
Other income
$xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
Form of the Income Statement
Other income (from previous page)
Other revenue and gains
Other expenses and losses
Income from continuing operations before
income taxes
Income taxes on continuing operations
Net income from Continuing Operations
$xxx
xxx
(xxx)
xxx
(xxx)
xxx
Form of the Income Statement
Continued:
Discontinued operations:
Loss from operations of discontinued
business segment (net of tax)
$xxx
Loss on disposal of segment (net of tax) xxx (xxx)
Extraordinary gain (net of tax)
xxx
Net income
$xxx
Cumulative Effect of a Change in
Accounting Principle (net of tax)
xxx
Net income
$xxx
=========
*Comprehensive items may be shown as a note to arrive at
Comprehensive Net Income
Form of the Income Statement
Comparative financial
statements present
several years’ financial
statements side
by side.
Consolidated
financial
This enables statements
users to
combine the
analyze performance
overresults of the
financial
multiple periods
and company” with
“parent
identify significant
trends.
other
companies that it
owns, called subsidiaries.
Income from Continuing
Operations
Determining Subtotals:
Income from Continuing Operations
Before Taxes =
Operating income + Other revenues and gain
– Other expenses and losses
Income from continuing operations =
Income from continuing operations before income
taxes – Income taxes on continuing operations
Components of the Income
Statement
•
1.
2.
3.
4.
5.
6.
Income from Continuing Operations:
Revenue
Cost of goods sold
Operating expenses
Other revenues and gains
Other expenses and losses
Income taxes on continuing
operations
Income from Continuing
Operations
Determining Subtotals:
Gross profit =
Revenue – Cost of goods sold
Operating income =
Gross profit – Operating expenses
Components of the Income
Statement
Revenue
Revenue reports the
total sales to
customers for the
period less any sales
returns and allowances
or discounts. Does not
include taxes or
shipping charges.
Components of the Income
Statement
Cost of Goods Sold
+
+
+
=
–
=
Beginning inventory
Net
purchases
Cost
of goods sold is a significant
item on merchandising and
Freight-in
companies’
Othermanufacturing
inventory acquisition
costs
income
statement.
Cost of goods
available
for sale
Ending inventory
Cost of goods sold
Components of the Income
Statement
Gross Profit
Net sales
– Cost of goods sold
= Gross profit
Why is Gross Profit important?
Gross profit ÷ Net sales
---what is
used for?
=itGross
profit
percentage
Components of the Income
Statement
Operating Expenses
Operating expenses may be
reported in two parts:
1) Selling expenses
List some examples
2) General and
Administrative expenses
List some examples
Components of the Income
Statement
Operating Income
Operating income measures the
performance of the fundamental
business operations conducted by
a company.
Gross profit
– Operating expenses
= Operating income
also call EBIT
Components of the Income
Statement
Other Revenues and Gains
This section usually includes
items identified with the peripheral
activities of the company.
List some examples:
1) Rent revenue
2) Interest revenue
3) Dividend revenue
4) Gains from the sale of assets
Components of the Income
Statement
Other Expenses and Losses
This section parallels “Other
Revenues and Gains” except the
items result in deductions from
operating income.
List some examples
1) Interest expense
2) Losses from the sale of assets
3) Restructuring charges
Components of the Income
Statement
Income Taxes
Income tax expense is calculated
on income from all transactions of
consequence for the year.
Below the line items (transitory,
irregular, and extraordinary
items) are reported net of their
individual tax effect.
See Techtronics, p. 166
Below the Line items
Discontinued operations:
Loss from operations of discontinued
business segment (net of tax)
$xxx
Loss on disposal of segment (net of tax) xxx (xxx)
Extraordinary gain (net of tax)
xxx
Net income
$xxx
Cumulative Effect of a Change in
Accounting Principle (net of tax)
xxx
Net income
$xxx
=========
Discontinued Operations
• Not expected to continue to impact
results of future years operations
• To report discontinued operations:
– The operations and cash flows of the
component must be clearly identifiable
– For example, discontinued operations
would result if a company closed one of
four operating segments which tracks its
cash flows and income separately. Or
may be closing of a single line or even a
single store.
Discontinued Operations
• Management could decide to dispose of a
component of a business because:
• The component may be unprofitable.
• The component may not fit into the longrange plans for the company.
• Management may need funds to reduce
long-term debt or to expand into other
areas.
• Management may be fearful of a corporate
takeover by new investors desiring to gain
control of the company.
Discontinued Operations
•
When reporting discontinued
operations on the income statement
it consists of two parts:
1. Income (loss) from operations- disclosed
only if decision to discontinue
operations is made after beginning of
the year.
2. Gain (loss) on disposal of operationconsisting of income (loss) during phase out and
gain (loss) from disposal of segment assets.
Discontinued Operations
According to FASB Statement No.
In addition
to the summary
144,
if on the balance
sheet date
assetsorand
liabilities
income
loss
numberassociated
reported in
with
discontinued
components
the
income
statement,
the total
have not
been completely
revenue
associated
with the
disposed, they
are to beshould
listed be
discontinued
operations
separately
in the
and
disclosed in
the asset
financial
liabilitystatement
sections ofnotes.
the balance
sheet.
Extraordinary Items
To be reported as
an
extraordinary
item the event
must be BOTH:
1. Unusual and
2. Infrequent.
Not Extraordinary—p. 174
• Write-down or write-off of
receivables, inventory, etc.
• Effects of a strike.
• Gains or losses from exchange or
remeasurement of foreign
currencies.
• Gains or losses on disposal of
business segment.
• Gains or losses from sale or
abandonment of productive
assets.
• Adjustment of accruals on longterm contracts.
Changes in Accounting
Principle
1. To provide more
useful
information (not
just for economic
purpose.)
2. Is usually the
result of a FASB
pronouncement
or SEC directive
Changes in Accounting
Principle
Disclosure Requirements:
1. Report current year’s income
components on the new basis.
2. Determine how the income
statement would be different in
past years if the new accounting
method would have been used;
see p. 176
Change in Estimate
 Estimates are always made using the
best available information at the
statement date
 Revision of estimates is normal, and
part of the continuing accounting
process
 Changes in estimates should be
reflected in the current period and
future periods. No retroactive
adjustments are made.
 Disclose as supplemental note
Net Income or Loss
• What is it?
Income or Loss from continuing operations
• Combined with the results of discontinued
operations and extraordinary items
• Provides a summary of the company’s
performance for a period
• Is often measured and compared using the
ratio of return on sales:
• Net Income / Net Sales
Earnings Per Share
• Represents the amount of
net income associated
with a share of common
stock
• EPS amounts are
computed for income from
continuing operations
• And EPS amounts are
calculated for each
irregular or extraordinary
item.
Earnings Per Share
Formula for Income from
Continuing Operations
Income from continuing operations*
Weighted average number of shares
of common stock outstanding
*less dividends paid or promised to Preferred
Stock
Earnings per Share
Basic EPS based on shares
actually outstanding during the
year
Diluted EPS represents additional
stock which may result from stock
options or other conversion rights
(resulting in a potentially larger
number of shares of stock)
Earnings Per Share
Price-Earnings Ratio
Market value per share
Earnings per share
Widely
referred to as
the PE ratio
Comprehensive Income
• Comprehensive income- the amount
that reflects the change in a
company’s wealth during the period.
• It includes items that arise from
changes in market conditions
unrelated to the business operations
of a company.
• Most companies include a report of
comprehensive income as part of the
statement of stockholders’ equity.
Comprehensive Income
The more common adjustments made in
arriving at comprehensive income are:
• Foreign currency translation
adjustments.
• Unrealized gains and losses on
available-for-sale securities.
• Deferred gains and losses on
derivative financial instruments.
Forecasting Future Performance
• Financial statements report the past,
but are used to predict the future.
• Key to a good forecast involves
identifying factors that determine a
certain level of revenue or expense.
• Forecasting starts with a forecast for
sales.
• Most expense forecast are driven from
the sales forecast.