Chapter 4 The Income Statement, Comprehensive Income, and the Statement of Cash Flows Copyright © 2015 McGraw-Hill Education. All rights reserved. The Income Statement, Comprehensive Income, and the Statement of Cash Flows Income Statement (Statement of Operations or Statement of Earnings) Displays a company’s operating performance Comprehensive Income (other comprehensive income (OCI) or loss) Includes a few types of gains and losses that are not part of net income Statement of Cash Flows Provides information about cash receipts and cash disbursements The Income Statement, Comprehensive Income, and the Statement of Cash Flows Reports changes in shareholders’ equity Income Statement Change Statements Statement of Cash Flows Reports events that caused change in cash Balance Sheet Position Statement LO4-1 Income from Continuing Operations • Includes the revenues, expenses, gains, and losses pertaining to transactions that probably will continue in future periods Revenues • Inflows of resources resulting from providing goods or services to customers Expenses • Outflows of resources incurred while generating revenue • Represent the costs of providing goods and services LO4-1 Recognition of Expenses Causal relationship Revenues Yes Expenses are reported in the same period that the related revenue is recognized Expenses Is it possible to establish a causal relationship between revenues and expenses? No Relate the expense to a particular period, allocate it over several periods, or expense it as incurred LO4-1 Income from Continuing Operations Gains and losses • Increases or decreases in equity from peripheral or incidental transactions of an entity Examples Gains and losses from the routine sale of equipment, buildings, or other operating assets and from the sale of investment assets LO4-1 Income from Continuing Operations Partial Income Statements (In millions, except earnings per share) Years Ended June 30 2016 2015 Single-Step Income Statement • Groups all revenues and gains together and all expenses and losses together LO4-1 Multiple-Step Income Statement • Reports series of intermediate subtotals Concept Check √ Which of the following captions would more likely be found in a single-step income statement? a. Total revenues and gains. b. Gross profit. c. Operating income. d. All of these answers are incorrect. A single-step income statement groups together all revenues and gains. LO4-2 Earnings Quality • Ability of reported earnings (income) to predict a company’s future earnings Transitory earnings Result from transactions that are: not likely to occur again in the foreseeable future likely to have a different impact on earnings in the future Permanent earnings Result from transactions that are likely to continue in the future There may be transitory earnings effects included in income from continuing operations LO4-2 Manipulating Income and Income Smoothing • Most executives prefer to report earnings that follow a smooth, regular, upward path ‘bank’ their earnings by understating $ Earnings 15% 15% Instead of: 30% Use the banked profits to polish results 0 Methods: • Income shifting - “channel stuffing” • Income statement classification - “big bath” accounting LO4-3 Partial Income Statement—GameStop Corp. • The extraordinary classification has now been eliminated from GAAP LO4-3 Operating Income and Earnings Quality Restructuring Costs Include costs associated with shutdown or relocation of facilities or downsizing of operations Recognized in the period the exit or disposal cost obligation actually is incurred Examples • Termination benefits payable to employees to be terminated: To be accrued in the period(s) the employees render their service • Costs associated with closing facilities: Recognized when services or goods associated with those activities are received LO4-3 Operating Income and Earnings Quality Long-lived asset impairments Any long-lived asset Tangible Intangible should have its balance reduced if there has been a significant impairment of value Examples of revenue issues affecting earnings quality: • A company loses a major customer that can’t be replaced • Premature revenue recognition due to pressure to meet earnings expectations LO4-3 Nonoperating Income and Earnings Quality Gains and losses Sale of investments Current earnings Significant LO4-3 Nonoperating Income and Earnings Quality Example: In 2000: Stock market boom Pro forma earnings: – Management’s assessment of permanent earnings – The Sarbanes-Oxley Act requires reconciliation between pro forma earnings and earnings determined according to GAAP LO4-3 Income Statements (in part)—Intel Corporation LO4-4 Discontinued Operations • Disposal of component(s) that represents a strategic shift that has, or will have, a major effect on a company’s operations and financial results • Reported separately, below income from continuing operations Discontinued operations, (expense)/ benefit Discontinued operations, netnet of of $xx$xx tax tax (expense)/ benefit Concept Check √ The Cansela Baseball Bat Company reported income before taxes of $375,000. This amount included a $75,000 loss on discontinued operations. The amount reported as income from continuing operations, assuming a tax rate of 40%, is: a. $375,000. b. $270,000. c. $180,000. d. $225,000. [$375,000 (income before income taxes) + $75,000 (loss on discontinued operations)] × [1.0 – 0.4 (tax rate)] = $270,000 LO4-4 Reporting Discontinued Operations Income or loss from operations of the component On disposal of the component’s assets When the component has been sold From the beginning of the reporting period to the disposal date Gain or loss on disposal of the component’s assets When the component is considered held for sale From the beginning of the reporting period to the end of the reporting period An “impairment loss” if the book value of the component is more than fair value minus cost to sell LO4-4 Discontinued Operations— Gain on Disposal The Duluth Holding Company has several operating divisions. In October 2016, management decided to sell one of its divisions that qualifies as a separate component according to generally accepted accounting principles. The division was sold on December 18, 2016, for a net selling price of $14,000,000. $14,000,000 On that date, the assets of the division had a book value of $12,000,000 $12,000,000. For the period January 1 through $4,200,000 The disposal, the division reported a pretax loss from operations of $4,200,000. company’s income tax rate is 40% on all items of income or loss. Duluth generated after-tax profits of $22,350,000 from its continuing operations. Duluth’s income statement for the year 2016, beginning with income from continuing operations, would be reported as follows: Income from continuing operations $22,350,000 _ _ Discontinued operations: Loss from operations of discontinued component $(2,200,000) × 40% Income tax benefit 880,000 Loss on discontinued operations (1,320,000) Net income $21,030,000 LO4-4 Discontinued Operations—Impairment Loss The Duluth Holding Company has several operating divisions. In October 2016, management decided to sell one of its divisions that qualifies as a separate component according to generally accepted accounting principles. On December 31, 2016, the end of the company’s fiscal year, the division had not yet been sold. On that date, the assets of the division had a book value of $12,000,000 $12,000,000 and a fair value, minus anticipated cost to sell, of $9,000,000 $9,000,000. For the year, the division reported a pre-tax loss from operations of $4,200,000 $4,200,000. The company’s income tax rate is 40% on all items of income or loss. Duluth generated after-tax profits of $22,350,000 from its continuing operations. Duluth’s income statement for 2016, beginning with income from continuing operations, would be reported as follows: Income from continuing operations $22,350,000 _ _ Discontinued operations: Loss from operations of discontinued component $(7,200,000) × 40% Income tax benefit 2,880,000 Loss on discontinued operations (4,320,000) Net income $18,030,000 Concept Check √ On October 1, 2016, American Medical Inc. adopted a plan to discontinue its generic drug division, which qualifies as a separate component of the business according to GAAP regarding discontinued operations. The disposal of the division was expected to be concluded by March 30, 2017. On December 31, 2016, the company's year-end, the following information relative to the discontinued division was accumulated: Operating loss for 2016 $195 million Excess of book value over fair value, less costs to sell, at year-end 25 million In its income statement for the year ended December 31, 2016, American would report a before-tax loss on discontinued operations of: a. $170 million. b. $195 million. c. $220 million. d. All of these answers are incorrect. $195 million operating loss plus a $25 million impairment loss. LO4-4 Discontinued Operations Disclosure—Eastman Kodak Company Concept Check √ The Trident Corporation’s results for the year ended December 31, 2016, include the following material items: Sales revenue Cost of goods sold Selling and administrative expenses Gain on sale of investments Loss on discontinued operations Restructuring costs $8,200,000 4,800,000 2,000,000 300,000 1,200,000 280,000 Trident Corporation’s income from continuing operations before income taxes for 2016 is: a. $1,120,000. b. $ 220,000. c. $1,700,000. d. $1,420,000. $8,200,000 – 4,800,000 -2,000,000 + 300,000 – 280,000 = $1,420,000 LO4-4 Accounting Changes Accounting changes fall into one of three categories accounting principle change in estimate reporting entity • Correction of an error is another adjustment that is accounted for in the same way as certain accounting changes LO4-4 Change in Accounting Principle • Refers to a change from one acceptable accounting method to another Voluntary changes in accounting principles • Accounted for retrospectively by revising prior years’ financial statements Example Change in inventory costing method from FIFO to average cost LO4-4 Change in Depreciation, Amortization, or Depletion Method • Accounted prospectively • Accounted for the same way as a change in an accounting estimate (see next slide) • One difference is that most changes in estimate don’t require a company to justify the change LO4-4 Change in Accounting Estimate • Changes due to revision of an estimate because of new information or new experience • Accounted prospectively • New estimate is incorporated in any related accounting determinations from that point on • If the effect of the change is material, a disclosure note is needed to describe the change and its effect on income Examples Amount of future bad debts on existing accounts receivable; useful life and residual value of a depreciable asset; and future warranty expenses LO4-4 Correction of Accounting Errors • Caused by a transaction being recorded incorrectly or not recorded at all Errors discovered in the same year Erroneous journal entry is reversed and the appropriate entry is recorded Material errors discovered in subsequent years Require a prior period adjustment LO4-4 Prior Period Adjustments • Required when a material error is discovered in the statements when published and distributed to shareholders • Requires that the company record a journal entry that: – adjusts any balance sheet accounts to their appropriate levels – accounts for the income effects of the error o By increasing or decreasing the beginning retained earnings balance in a statement of shareholders’ equity LO4-5 Earnings per Share Disclosures • Ratio that indicates the amount of income earned by a company expressed on a per share basis Reported on the face of Basic EPS the income statement Diluted EPS Net income – Preferred stock dividends Basic EPS = Weighted-average number of common shares outstanding Illustration: $600,000 – $75,000 $525,000 Basic EPS = = 9 1,000,000 + 1,000,000 ( /12) $1,750,000 = $0.30 LO4-5 Earnings per Share Disclosures Diluted EPS • Reflects the potential dilution that could occur for companies that have certain securities outstanding that are convertible into common shares or stock options that could create additional common shares if the options were exercised • These items could cause EPS to decrease (become diluted) because there would be more shares in the denominator of the EPS calculation LO4-5 EPS Disclosures—Big Lots, Inc. LO4-6 Comprehensive Income • Is the total change in equity for a reporting period other than from transactions with owners o Includes net income as well as other gains and losses that change shareholders’ equity but are not included in traditional net income • These other gains and losses are reported as other comprehensive income (OCI) loss items OCI items: • Net unrealized holdings gains and losses on investments • Gains (losses) from and amendments to postretirement benefit plans • Deferred gains (losses) from derivatives • Gains (losses) from foreign currency translation Concept Check √ Each of the following would be reported as an item of other comprehensive income except: a. Gains from and amendments to postretirement benefit plans. b. Foreign currency translation gains. c. Gains on sale of investments. d. Unrealized losses on investments accounted for as securities available for sale. Gains on sale of investments are included in the determination of net income. LO4-6 Flexibility in Reporting Information in the income statement and other comprehensive income items can be presented as: Single, continuous statement of comprehensive income Statement of comprehensive income Two separate, but consecutive statements Income statement Statement of comprehensive income LO4-6 Comprehensive Income Presented as a Separate Statement Comprehensive Income–Astro Med Inc. LO4-6 Accumulated Other Comprehensive Income • Cumulative total of OCI (or comprehensive loss) • Reported as an additional component of shareholders’ equity LO4-6 Shareholders’ Equity—Astro-Med Inc. ($ in thousands) Balance, 1/31/13 Add: Net income Deduct: Dividends Other comprehensive income Balance, 1/31/14 Retained Earnings $36,092 3,212 (2,103) $37,201 Accumulated Other Comprehensive Income $173 3 $176 Example: Relationship between net income and other comprehensive income LO4-6 • Philips Corp. purchased shares for $90 million during the year and sold them at year-end for $100 million Accumulated Other ($ in millions) Balance, 12/31/15 Net income (100 + ) Dividends Other comprehensive income Balance, 12/31/16 Comprehensive Income $34 Retained Earnings $600 106 (40) $666 + -0$34 $700 100 – 90 = 10 10 – 10 (0.4) = 6 • If the shares are not sold before the end of the fiscal year but the yearend fair value is $100 million Accumulated Other ($ in millions) Balance, 12/31/15 Net income Dividends Other comprehensive income Balance, 12/31/16 Comprehensive Income $34 Retained Earnings $600 100 (40) $660 + $40 $700 LO4-7 Statement of Cash Flows • Provides information about the cash receipts and cash disbursements of an enterprise that occurred during a period • Cash refers to cash plus cash equivalents • Presented for each period • Helpful in assessing future profitability, liquidity, and long-term solvency Operating activities Categories of transactions affecting cash Investing activities Financing activities LO4-8 Operating Activities • Inflows and outflows of cash that result from activities reported in the income statement Operating Activities Cash Inflows • Sale of goods or services • Interest and dividends from investments Cash Outflows • Purchase of inventory • Salaries, wages, and other operating expenses • Income taxes • Net cash flows from operating activities: Difference between the inflows and outflows Concept Check √ Which of the following items would not be included as a cash flow from operating activities in a statement of cash flows? a. Purchase of inventory. b. Purchase of machinery. c. Payment of income taxes. d. Collection of interest on a note. The purchase of machinery is an investing activity. LO4-8 Direct and Indirect Methods of Reporting Two generally accepted formats can be used to report operating activities: Direct Method Indirect Method Cash effect of each operating activity is reported directly in the statement Net cash flow is derived indirectly by starting with reported net income and adding or subtracting items to convert that amount to a cash basis LO4-8 Contrasting the Direct and Indirect Methods of Presenting Cash Flows from Operating Activities LO4-8 Direct Method of Presenting Cash Flows from Operating Activities Accounts Receivable Beg. bal. 0 Revenue 90 78 End. bal. 12 Cash Concept Check √ Bledsoe Motors reported revenue of $7,500,000 for its year ended December 31, 2016. Accounts receivable at December 31, 2015 and 2016, were $480,000 and $532,500, respectively. Using the direct method for reporting cash flows from operating activities, Bledsoe Motors would report cash collected from customers of: a. $7,500,000. b. $7,552,500. c. $7,567,500. d. $7,447,700. $480,000 + 7,500,000 – 532,500 = $7,447,500 LO4-8 Indirect Method of Presenting Cash Flows from Operating Activities Concept Check √ Kringle Pastries reported net income of $432,000 for its year ended December 31, 2016. Purchases of merchandise totaled $304,000. Accounts payable balances at the beginning and end of the year were $72,000 and $66,000, respectively. Beginning and ending inventory balances were $88,000 and $92,000, respectively. Assuming that all relevant information has been presented, Kringle Pastries would report operating cash flows of: a. $310,000. b. $442,000. c. $422,000. d. $302,000. Net income Deduct increase in inventory Deduct decrease in account payable Cash flows from operating activities $432,000 (4,000) (6,000) $422,000 LO4-8 Investing Activities • Include inflows and outflows of cash related to the acquisition and disposition of long-lived assets used in the operations of the business and investment assets • Purchase and sale of inventories are not considered investing activities LO4-8 Investing Activities • Cash outflows include cash paid for: o Purchase of long-lived assets used in the business o Purchase of investment securities like stocks and bonds of other entities Other than those classified as o Loans to other entities cash equivalents and trading securities • Cash inflows: o The sale of long-lived assets used in the business o The sale of investment securities o The collection of a nontrade receivable (excluding the collection of interest, which is an operating activity) LO4-8 Financing Activities • Relate to the external financing of the company Financing Activities Cash Inflows Cash Outflows • From owners when shares are sold to them • From creditors when cash is borrowed through notes, loans, mortgages, and bonds • To owners in the form of dividends or other distributions • To owners for the reacquisition of shares previously sold • To creditors as repayment of the principal amounts of debt (excluding trade payables that relate to operating activities) LO4-8 Noncash Investing and Financing Activities • Activities that do not involve cash flows at all • Reported on the face of the statement of cash flows or in a disclosure note Example: Acquisition of equipment (an investing activity) by issuing either a long-term note payable or equity securities (a financing activity) LO4-8 Statement of Cash Flows (beginning with Net cash flows from operating activities) LO4-9 International Financial Reporting Standards U.S. GAAP IFRS Income Statement Presentation No minimum requirements. Require certain minimum information to be reported on the face of the income statement. SEC regulations require expenses be classified by function. Allow expenses to be classified either by function or by natural description. “Bottom line” of the income statement usually is called either net income or net loss. Description of the bottom line of the income statement is either profit or loss. Comprehensive Income Companies are allowed to report comprehensive income in either a single statement of comprehensive income or in two separate, but consecutive statements. Same as under U.S GAAP. Other comprehensive income items are similar under both standards. However, an additional OCI item, changes in revaluation surplus, is possible under IFRS. LO4-9 International Financial Reporting Standards U.S. GAAP IFRS Classification of Cash Flows Cash outflows for interest payments and cash inflows from interest and dividends received as operating cash flows. Dividends paid to shareholders are classified as financing cash flows. Interest and dividends paid can be classified as either operating or financing cash flows and interest and dividends received as either operating of investing cash flows. Appendix 4 Interim Reporting Interim reports: • Issued for periods of less than a year, typically as quarterly financial statements To enhance the timeliness of financial information Objectives Downside To provide investors and creditors with additional insight on the seasonality of business operations Relative unreliability Intensified effect of unusual events Appendix 4 Interim Data in Annual Report—PetSmart, Inc. Appendix 4 Interim Reporting Reporting Revenues and Expenses: • Most revenues and expenses are recognized using the same accounting principles applicable to annual reporting • Most are recognized in interim periods as incurred • An expenditure that benefits more than just the period in which it is incurred, should be allocated among the periods benefited • Income tax expense at each interim date should be based on estimates of the effective tax rate for the whole year Appendix 4 Interim Reporting Reporting Unusual Items: • Discontinued operations should be reported separately in the interim period in which they occur – Not allocated among individual quarters Appendix 4 Interim Reporting • Earning Per Share: – Quarterly EPS calculations follow the same procedures as annual calculations – Based on conditions actually existing during the particular interim period • Reporting Accounting Changes: – Reported retrospectively by applying the changes to prior financial statements Appendix 4 Interim Reporting • Requires only certain Minimum Disclosures: o Sales, income taxes, and net income. o Earnings per share. o Seasonal revenues, costs, and expenses. o Significant changes in estimates for income taxes. o Discontinued operations and unusual items. o Contingencies. o Changes in accounting principles or estimates. o Information about fair value of financial instruments and the methods and assumptions used to estimate fair values. o Significant changes in financial position. LO4-9 International Financial Reporting Standards U.S. GAAP IFRS Interim Reporting Costs are accrued or deferred and then charged to each of the periods they benefit. Requires that a company apply the same accounting policies in its interim financial statements as it applies in its annual financial statements. Costs are expensed entirely in the period in which they occur. Interim period income is less volatile than under IFRS. Interim period income is more volatile under IFRS than under U.S. GAAP. Income taxes are accounted for based on an estimate of the tax rate expected to apply for the entire year. Same as under U.S.GAAP. End of Chapter 4