Chapter 4: Learning Objectives
1. Understand the uses and limitations of an income statement.
2. Prepare a single-step income statement.
3. Prepare a multiple-step income statement.
4. Explain how to report irregular items.
5. Explain intraperiod tax allocation.
6. Identify where to report earnings per share information.
7. Prepare a retained earnings statement.
8. Explain how to report other comprehensive income.
Income statement (statement of earnings): is the report that measures the success of
company operations for a given period of time.
It is used to determine profitability, investment value and creditworthiness.
I.S. helps users to predict amounts, timing and uncertainty of future cash flow in a number
of way.
Usefulness
 Evaluate past performance.
 Predicting future performance.
 Help assess the risk or uncertainty of achieving future cash flows.
Limitations
 Companies omit items that cannot be measured reliably.
 Income is affected by the accounting methods employed e.g. method of
depreciation.
 Income measurement involves judgment e.g. estimating the assets’ useful life.
Quality of Earnings
Companies have incentives to manage income to meet or beat stock market (e.g. Wall
Street) expectations, so that
 market price of stock increases and
 value of stock options increase.
Quality of earnings is reduced if earnings management results in information that is less
useful for predicting future earnings and cash flows.
(In such cases: Earning management negatively affects the quality of earnings)
*Market relies on trust.
*Quality of earnings is important in order to increase investors’ confidence in the I.S.
Elements of the Income Statement
Revenues – Inflows or other enhancements of assets or settlements of its liabilities that
constitute the entity’s ongoing major or central operations e.g. Sales, Fee revenue,
Interest revenue, Dividend revenue, Rent revenue.
Expenses – Outflows or other using-up of assets or incurrences of liabilities that constitute
the entity’s ongoing major or central operations e.g. Cost of goods sold, Depreciation
expense, Interest expense, Rent expense and Salary expense.
Gains – Increases in equity (net assets) from peripheral or incidental transactions.
Losses - Decreases in equity (net assets) from peripheral or incidental transactions.
Gains and losses can result from
 sale of investments or plant assets,
 settlement of liabilities,
 write-offs of assets.
E.g. when McDonald’s sells land, it records any excess of the selling price over the book
value as a gain, (because its not a part of McDonald’s regular operations)
Single-Step income statement Format:
The single-step statement consists of just two groupings:
Revenues
-(Expenses)
=Net Income
* No distinction between Operating and Non-operating categories.
Income Statement (in thousands)
Revenues:
Sales
Interest revenue
Total revenue
$ 285,000
17,000
302,000
Expenses:
Cost of goods sold
Selling expense
Administrative expense
Interest expense
Income tax expense
Total expenses
149,000
10,000
43,000
21,000
24,000
247,000
Net income
$ 55,000
Earnings per share
$
0.75
Income Statement
For the year ended Dec. 31, 2011
Administrative
expense:
Officers' salaries
Depreciation
Cost of goods sold
Rental revenue
Selling expense:
Transportation-out
Sales commissions
Depreciation
Sales
Income tax expense
Interest expense
$4,900
3,960
63,570
17,230
2,690
7,980
6,480
96,500
7,580
1,860
Revenues:
Sales
Rental revenue
Total revenues
Expenses:
Cost of goods sold
Selling expense
Administrative expense
Interest expense
Income tax expense
Total expenses
Net income
$96,500
17,230
113,730
63,570
17,150
8,860
1,860
7,580
99,020
$14,710
The single-step income statement emphasizes
a. the gross profit figure.
b. total revenues and total expenses.
c. extraordinary items more than it is emphasized in the multiple-step income
statement.
d. the various components of income from continuing operations.
Multiple-Step Income statement Format
Background
 Separates operating transactions from non-operating transactions.
 Classification of expenses by functions such as merchandising, selling and
administration.
 Matches costs and expenses with related revenues.
 Highlights certain intermediate components of income that analysts use e.g.
computing ratios for assessing the performance of the company
Income Statement Sections
1. Operating section: result from the company’s principle/central operations.
a) Sales or revenue section including sales, discounts, allowances & returns.
b) Cost of goods sold section.
c) Selling expenses
d) Administrative or general expenses.
2. Nonoperating section: result from secondary activities of the company i.e. special
gains and losses that are infrequent or unusual (but not both) are reported in this
section.
a) Other revenues and Gains.
b) Other Expenses and losses.
3.
4.
5.
6.
Income tax.
Discontinued operations.
Extraordinary items: unusual and infrequent material gains and losses.
Earnings per share
Exercises:
A separation of operating and non operating activities of a company exists in
a. both a multiple-step and single-step income
statement.
b. a multiple-step but not a single-step income
statement.
c. a single-step but not a multiple-step income
statement.
d. neither a single-step nor a multiple-step income statement.
Income Statement
For the year ended Dec. 31, 2011
Administrative expense:
Officers' salaries
Depreciation
Sales
$
4,900
3,960
Cost of goods sold
63,750
Operating Expenses:
Rental revenue
17,230
Selling expense
2,690
Sales commissions
7,980
Income from operations
Depreciation
6,480
Other revenue (expense):
Sales
32,750
17,150
Administrative exense
Transportation-out
96,500
Income tax expense
7,580
Interest expense
1,860
8,860
Total operating expenses
26,010
6,740
Rental revenue
17,230
Interest expense
(1,860)
Total other
15,370
Income before tax
22,110
Income tax expense
Net income
96,500
63,750
Gross profit
Cost of goods sold
Selling expense:
$
7,580
$
14,530
Irregular items fall into six categories
1. Discontinued operations.
2. Extraordinary items.
3. Unusual gains and losses.
4. Changes in accounting principle.
5. Changes in estimates.
6. Corrections of errors.
Discontinued Operations (most common type) occurs when,
(a)
company eliminates the
 results of operations and
 cash flows of a component from its ongoing operation.
(b)
there is no significant continuing involvement in that component after disposal
transaction.
*e.g. Each product group is a component of the company.
Companies report as discontinued operations (in a separate I.S. category) the gain or loss
from disposal of a component of a business. Also, companies report the results of
operations of a component that has been or will be disposed of separately from continuing
operation.
* Companies show the effect of discontinued operation “net of tax” as a separate
category, after continuing operations but before extraordinary items.
Illustration: KC Corporation had after tax income from continuing operations of
$55,000,000 in 2008. During 2008, it disposed of its restaurant division at a pretax loss of
$270,000. Prior to disposal, the division operated at a pretax loss of $450,000 in 2008.
Assume a tax rate of 30%. Prepare a partial income statement for KC.
Income from continuing operations $55,000,000
Discontinued operations:
Loss from operations, net of $135,000 tax 315,000
Loss on disposal, net of $81,000 tax 189,000
Net income $54,496,000
Extraordinary items
are nonrecurring material items that differ significantly from a company’s typical business
activities.
Extraordinary Item (rare) must be both of an
 Unusual Nature and
 Occur Infrequently
Company must consider the environment in which it operates.
Amount reported “net of tax” in a separate section of the I.S.
e.g. if resulted directly from a major casualty (earthquake), an expropriation or a
prohibition under a newly enacted law or regulation.
Q: Are these items Extraordinary?
(a)
A large portion of a tobacco manufacturer’s crops are destroyed by a hail storm.
Severe damage from hail storms in the locality where the manufacturer grows tobacco is
rare (YES).
(b)
A citrus grower's Florida crop is damaged by frost (NO).
(c)
A company sells a block of common stock of a publicly traded company. The block
of shares, which represents less than 10% of the publicly-held company, is the only
security investment the company has ever owned (YES).
(d)
A large diversified company sells a block of shares from its portfolio of securities
which it has acquired for investment purposes. This is the first sale from its portfolio of
securities (NO).
(e) An earthquake destroys one of the oil refineries owned by a large multi-national oil
company. Earthquakes are rare in this geographical location (YES).
(f)
A company experiences a material loss in the repurchase of a large bond issue that
has been outstanding for 3 years. The company regularly repurchases bonds of this
nature (NO).
Illustration: KC Corporation had after tax income from continuing operations of
$55,000,000 in 2007. In addition, it suffered an unusual and infrequent pretax loss of
$770,000 from a volcano eruption. The corporation’s tax rate is 30%. Prepare a partial
income statement for KC Corporation beginning with income from continuing operations.
Income from continuing operations $55,000,000
Extraordinary loss, net of $231,000 tax
539,000
Net income $54,461,000
($770,000 x 30% = $231,000 tax)
Income Statement (in thousands)
Sales
Cost of goods sold
$ 285,000
149,000
Interest expense
Total other
Income before taxes
Income tax expense
Income from continuing operations
(21,000)
(4,000)
79,000
24,000
55,000
Discontinued
Operations
Discontinued operations:
Loss from operations, net of tax
315
Loss on disposal, net of tax
189
Total loss on discontinued operations
504
Income before extraordinary item
54,496
Extraordinary loss, net of tax
Net income
539
$
53,957
Extraordinary Item
Q: Irregular transactions such as discontinued operations and extraordinary items should
be reported separately in
a. both a single-step and multiple-step income statement.
b. a single-step income statement only.
c. a multiple-step income statement only.
d. neither a single-step nor a multiple-step income statement.
Unusual Gains and Losses
Material items that are unusual or infrequent, but not both, should be reported in a
separate section just above “Income from continuing operations before income taxes.”
Examples can include:
 Write-downs of inventories
 Foreign exchange transaction gains and losses (from fluctuation)
The Board prohibits net-of-tax treatment for these items.
When preparing a multiple-step income statement for homework purposes you should
report unusual gains and losses in the “other revenue and gains” or “other expenses and
losses” section UNLESS you are instructed to prepare a separate unusual items section.
Changes in Accounting Principles
 A company recognizes a change in accounting principle by making a
retrospective adjustment to the F. S.
 The company records the cumulative effect adjustment (for prior periods) to
beginning retained earnings
 Approach preserves comparability
 Examples include:
 change from FIFO to average cost
Changes in Estimate
 Accounted for in the period of change and future periods
 Not handled retrospectively
 Not considered errors or extraordinary items
 Examples include:
 Useful lives and salvage values of depreciable assets
 Allowance for uncollectible receivables
 Inventory obsolescence

Change in Estimate: Arcadia HS, purchased equipment for $510,000 which was
estimated to have a useful life of 10 years with a salvage value of $10,000 at the end of
that time. Depreciation has been recorded for 7 years on a straight-line basis. In 2010
(year 8), it is determined that the total estimated life should be 15 years with a salvage
value of $5,000 at the end of that time.
Questions:
 What is the journal entry to correct the prior years’ depreciation? No Entry
 Calculate the depreciation expense for 2010.
Equipment cost
Salvage value
Depreciable base
Useful life (original)
Annual depreciation
$510,000
- 10,000
500,000
10 years
$ 50,000
Balance Sheet (Dec. 31, 2009)
Fixed Assets:
Equipment
Accumulated depreciation
Net book value (NBV)
Net book value
Salvage value (new)
Depreciable base
Useful life remaining
Annual depreciation
First, establish NBV
at date of change in
estimate.
x 7 years = $350,000
$510,000
350,000
$160,000
$160,000
5,000
155,000
8 years
$ 19,375
Journal entry: Depreciation expense 19,375
Accumulated depreciation
19,375
Corrections of Errors
 Result from:
 mathematical mistakes
 mistakes in application of accounting principles
 oversight or misuse of facts that existed when F.S. were prepared
 Corrections treated as prior period adjustments
 The correction of an error is reported in the year in which it is discovered.
 Adjustment to the beginning balance of retained earnings
Corrections of Errors: To illustrate, in 2011, Hillsboro Co. determined that it incorrectly
overstated its accounts
receivable and sales revenue by $100,000 in 2010. In 2011, Hillboro makes the following
entry to correct for this error (ignore income taxes).
Retained earnings
Accounts receivable
100,000
100,000
Special Reporting Issues
Net income - Preferred dividends
Weighted average number of shares outstanding
 An important business indicator.
 Measures the dollars earned by each share of common stock.
 Must be disclosed on the income statement.
Earnings Per Share (BE4-8): In 2010, Hollis Corporation reported net income of
$1,000,000. It declared and paid preferred stock dividends of $250,000. During 2010,
Hollis had a weighted average of 190,000 common shares outstanding. Compute Hollis’s
2010 earnings per share.
(1,000,000- 250,000) / 190,000 = 3.95 per share
Retained Earnings Statement
Increase
Net income
Change in accounting principle
Error corrections
Decrease
Net loss
Dividends
Change in accounting principle
Error corrections
Woods, Inc.
Statement of Retained Earnings
For the Year Ended December 31, 2011
Balance, January 1
Net income
Dividends
Balance, December 31
$
$
1,050,000
360,000
(300,000)
1,110,000
Before issuing the report for the year ended December 31, 2011, you discover a $50,000
error (net of tax) that caused 2010 inventory to be overstated (overstated inventory caused
COGS to be lower and thus net income to be higher in 2010). Would this discovery have
any impact on the reporting of the Statement of Retained Earnings for 2011?
Woods, Inc.
Statement of Retained Earnings
For the Year Ended December 31, 2007
Balance, January 1, as previously reported
Prior period adjustment - error correction
Balance, January 1, as restated
Net income
Dividends
Balance, December 31
$
$
1,050,000
(50,000)
1,000,000
360,000
(300,000)
1,060,000
*Note: The reconciliation of the beginning to the ending balance in retained earnings
provides information about why net assets increased or decreases during the year.
Restricted Retained Earnings
To comply with contractual requirement or board of directors’ policy.
Disclosed
 In notes to the financial statements
 As Appropriated Retained Earnings
[1. Retained earnings free (unrestricted).
2.Retained earnings appropriated (restricted)]
= total retained earnings.
Comprehensive Income
All changes in equity during a period except those resulting from investments by
owners and distributions to owners.
Includes:
 All revenues and gains, expenses and losses reported in net income, and
 All gains and losses that bypass net income but affect stockholders’ equity.