CHAPTER 6
THE
INCOME
STATEMENT
Introduction
Various groups are affected by, and have a stake in, the financial
reporting requirements of the FASB and the SEC
Introduction
Investors in equity securities are the central focus of
the financial reporting environment
Introduction
Investing involves




giving up current resources
for future uncertain resources.
Therefore, investors require information assessing
future cash flows.
The Economic Consequences of
Financial Reporting

Financial reporting has economic consequences including:
1
Financial information can affect the distribution of wealth among investors.

More informed investors, or investors employing security analysts, may be able to
increase their wealth at the expense of less informed investors.
The Economic Consequences of
Financial Reporting
2
Financial information can affect the level of risk accepted by a
firm.

3
Focusing on short-term, less risky, projects may have long-term
detrimental effects.
Financial information


can affect the rate of capital formation in the economy
and result in a reallocation of wealth between consumption and investment within the
economy.
The Economic Consequences of
Financial Reporting
4
Financial information can affect how investment is allocated among firms.

These economic consequences may have a differential impact on different user
groups and future deliberations of standards must consider these economic
consequences
Elements of the Income Statement

SFAC No. 1 indicates that the primary
focus of financial reporting is to
provide information about a
company’s performance

The income statement reports on performance and the
elements of the income statement were defined in SFAC
No. 6 as:




Revenues
Gains
Expenses
Losses
Each Term Is Defined As Changes in
Assets and Liabilities

Differences between changes in assets approach and inflow and outflow
definition are:
1.
2.
Change in net economic
resources
Measure of
effectiveness
Definition of Assets and Liabilities
Earnings
3.
VS
Creation of deferred
charges when measuring
income
VS
VS
Revenue & Expenses
Recognition when they
are economic resources
or obligations
Each Term Is Defined As Changes in
Assets and Liabilities
4.
5.
Both agree on importance of income statement
The change in asset
approach limits the
population from which
elements can be selected
to net economic
resources.
VS
The flows method
includes items
necessary to match
Statement Format


1
2
The preparation of the income statement
has been impacted by differences of
opinion on the definition of ongoing
operations.
Two views:
All inclusive
Current operating performance
Current Income Statement Format

Proscribed in APB Opinion No. 9 as:
Revenues
Less: Cost of goods sold
= Gross profit
Less: Administrative and selling expenses
Plus: Other gains
Less: Other losses
= Income from continuing operations
Discontinued operations
Extraordinary items
Change in accounting principle
= Net income
Income From Continuing Operations




Normal and recurring revenues and expenses
Sustainable income
Income tax
Nonrecurring items



Discontinued operations
Extraordinary items
Change in accounting principle
Tootsie Roll and Hershey’s

Tootsie Roll Industries and The Hershey Company
are internationally known candy manufacturers.

We will use information from the two companies’ fiscal 2001 2005 annual reports to illustrate the disclosure of information
in this and subsequent chapters.
Discontinued Operations

Why special treatment?

Arise from a disposal of a segment of a business

Comprised of two elements
Gain or loss on disposed assets
Gain or loss on operations during the disposal periods

When to report
Measurement date
Disposal date

Neither Hershey’s nor Tootsie Roll disclosed any discontinued operations
for fiscal years 2003-2005
SFAS No. 144

Changed reporting of discontinued operations:




Unit must qualify as a component (distinguishable assets
and cash flows
Operations and cash flows of component must be
eliminated
Company does not retain any significant involvement in
operations of component
Neither Hershey or Tootsie Roll disclosed any
discontinued operations
Extraordinary Items






Original definition
Problems
APB No. Opinion No. 30
Unusual nature
Infrequency of occurrence
Problem:
 Requirements do not always separate recurring and non-recurring
items
 As a result, there is a tendency to increase the variability of operating
income and decrease the predictive ability of earnings
The events of 9/11
Neither company discloses any extraordinary items for the years
presented
Accounting Changes


The accounting standard of consistency requires that similar
transactions should be reported similarly each year

Occasionally an entity may find that reporting needs are better served
by changing a method of accounting

If so, the comparability of financial statements is impaired
Basic question: Should previously issued financial statements be
amended?
Types of Accounting Changes

Change in accounting principle

How reported



APB Opinion No 20
SFAS No 154
Hershey’s CAP was due to a change in the method of accounting for special
purpose entities as required by the FASB

Change in accounting estimate


Change in accounting entity


How reported
How reported
Error

How reported
Earnings Per Share

Basic calculation
Net income - Preferred dividends
Average # of common shares outstanding





APB No. 15
Simple vs. complex capital structure
Required calculation of primary and fully diluted
earnings per share
Criticism of APB No. 15
The FASB and IASC project
SFAS No. 128

Reasons for the change
1
Basic EPS and diluted EPS data would give users the most factually range of
possibilities
2
Use of a common international method is important due to the data based
oriented financial analysis and internationalization of business
3
The notion of common stock equivalents does not operate efficiently in practice
4
The computation of primary EPS is complex and not well understood or
consistently applied
5
Presenting basic EPS eliminates criticism about the arbitrary nature of the
determination of common stock equivalents
SFAS No. 128

Requires presentation of EPS by all publicly traded
companies issuing common stock

Companies with a simple capital structure will only report
basic earnings per share. All others will report basic and
diluted

Calculation of basic EPS
Net income - Preferred dividends
Average # of common shares outstanding
Diluted Earnings Per Share

Objective



Calculation:
Includes all potential dilutive securities
Options and warrants - treasury stock method
Convertible securities
Continently issuable securities

1
2
3
Historical - basic
Pro forma - diluted
Usefulness of EPS

Objectives of EPS reporting are to provide investors an indication of :
1
Value of the firm
2
Expected future dividends

Question: Historical or forecasted?

Summary indicator

Both Best Buy and Circuit City have complex capital structure

disclose basic as well as diluted earnings per share on their their fiscal 2003
income statements
SFAC No. 5 - Recognition and
Measurement

Comprehensive income definition:


The change in net assets of an entity from
non-owner transactions
Attempts to combine Hicksian capital maintenance
approach with traditional accounting transactions
approach
SFAC No. 5 - Recognition and
Measurement

A full set of financial statements shall show:
Comprehensive
income
Earnings
Investments
by and
distributions
to owners
SFAS No. 5 - Recognition and
Measurement
Comprehensive income
Revenues
Less: Expenses
Plus: Gains
Less: Losses
= Earnings
Earnings
Plus or minus cumulative accounting adjustments
Plus or minus other nonowner
changes in equity
= Comprehensive income
Measurement Issues

Definitions.


Measurability.


It has a relevant attribute, measurable with sufficient reliability.
Relevance.


The item meets the definition of an element contained in SFAC No.
6.
The information about the item is capable of making a difference in
user decisions.
Reliability.

The information is representationally faithful, verifiable, and
neutral.
SFAS No 130 - Reporting
Comprehensive Income

Reasons for the initial project
1
Off-balance sheet financing
2
The practice of reporting some items of
comprehensive income in
stockholders’ equity
3
Acknowledged need for harmonization
of accounting standards
Definitions

Comprehensive income


the change in equity (net assets) of a business
enterprise during a period from transactions and other
events and circumstances from nonowner sources.
Other comprehensive income

revenues, expenses, gains, and losses included in
comprehensive income but excluded from net income.
SFAS No 130 - Reporting
Comprehensive Income

Original issues:
1. Should comprehensive income be reported?
2. Should cumulative accounting adjustments be included in
comprehensive income?
3. How should the components of comprehensive income be classified for
disclosure?
4. How should comprehensive income be disclosed
in the financial statements?
5. Should the components of other comprehensive
income be disclosed before or after their related
tax effects?
Should Comprehensive Income Be
Reported?

SFAS No 130



Requires the disclosure of comprehensive
income and
Discusses how to report and disclose
comprehensive income and its components,
including net income.
Does not specify when to recognize or how to
measure components
Should Cumulative Accounting
Adjustments Be Included?
Include
Cumulative Accounting
Adjustments
As Part Of
Comprehensive Income
Cumulative
Accounting
Adjustments
How Should the Components of
Comprehensive Income Be Classified
for Disclosure?

Requirement:

Companies must disclose an
amount for net income

That amount must be accorded equal
prominence with the amount disclosed for
comprehensive income

Items of other comprehensive income are
classified based on their nature
How Should Comprehensive Income be
Disclosed in the Financial Statements?

Requires a gross disclosure technique for items
of other comprehensive income

Allows for the disclosure of comprehensive
income

On income statement

On a separate statement

On the statement of stockholders’ equity
Should Components of Other Comprehensive
Income Be Displayed Before or After Their
Related Tax Effects.

Allows the components of other comprehensive income
to be disclosed either





Net of related tax effects or
Before related tax effects with one amount shown for the
aggregate income tax expense or benefit related to the total
amount of other comprehensive income
Other comprehensive income is transferred to a
separate component of stockholders’ equity
Hershey’s discloses changes in other comprehensive
income in its consolidated statement of shareholders’
equity as a single net amount.
Tootsie Roll includes the calculation of other
comprehensive income on its income statement.
Prior Period Adjustments

An adjustment to beginning retained
earnings balance

Original criteria in APB No. 9


Examples were income tax
disputes and litigation
SEC Staff Bulletin No. 8
and APB Opinion No. 16

Correction of an error

Adjustments from realization of operating loss carryforward
of purchased subsidiary
Financial Performance Reporting by
Business Enterprises


In 2001 FASB initiated a project to
redesign the income statement.
This project termed Financial Performance Reporting by
Business Enterprises has two main objectives:
1.
2.
To improve the quality of information
disclosed in financial statements to that
investors, creditors and other interested
parties are able to better evaluate an
enterprise’s financial performance
To ascertain that the financial statements
provide sufficient information to permit the
calculation of key financial performance
measures.
Financial Performance Reporting by
Business Enterprises

While no final conclusions had been drawn when this book was published,
some tentative decisions have been offered:
A single statement of comprehensive income should be prepared that reports all items of
revenue, expense, gains and losses.
The statement of comprehensive income should report three major categories
1.
2.
a.
Business activities
b.
Financing
c.
Other
3.
Income tax expense should be reported separately after the categories.
4.
Income from continuing operations should be disclosed as a subtotal
Discontinued operations are to be presented as a separate classification net of their tax effects
after income tax expense.
Other comprehensive income is also presented
5.
6.
7.
The cumulative effect of a change in accounting principle is included in other comprehensive
income.
8.
Extraordinary items will be reported in the appropriate major category before tax and will not be
labels as extraordinary.
The Value of Corporate Earnings

The financial analysis of a company’s income
statement focuses on a company’s operating
performance by focusing on such questions as:
1.
2.
3.
4.
5.
What are the company’s major sources of revenue?
What is the persistence of a company’s revenues?
What is the company’s gross profit ratio?
What is the company’s operating profit margin?
What is the relationship between earnings and the market
price of the company’s stock?
Sources of Revenue


The financial analysis of a diversified company requires a
review of the impact of various business segments on the
company as a whole.
Hershey’s reports segmental information for two segments:



Tootsie Roll reports segmental information for two
segments:



domestic
international
domestic
international
Neither company discloses any information about major
customers.
Persistence of Revenues
5-Year Revenue Trend Analysis
140%
120%
100%
80%
60%
40%
20%
0%
100%
100%
124.5%
116.9%
2001 2002 2003 2004 2005
Hershey's
Tootsie
Management’s Discussion
and Analysis

The MD&A section of a company’s annual report can provide
valuable information on the persistence of a company’s earnings
and its related costs.
 SEC requires companies to disclose any changes or potential
changes in revenues and expenses to assist in the evaluation of
period-to-period deviations.
 Examples of these disclosures include





unusual events
expected future changes in revenues and expenses
the factors that caused current revenues and expenses to increase or
decrease
trends not otherwise apparent from a review of the company’s
financial statements
An expanded discussion of the MD&A section of the annual
report is contained in Chapter 17.
Gross Profit Analysis
Gross Profit Percentage = Gross profit ÷ net sales
5-Year Gross Profit Trend Analysis
50.0%
40.0%
44.4%
43.5%
43.3%
41.8%
38.7%
39.5%
38.7%
39.0%
37.8%
35.5%
30.0%
20.0%
10.0%
0.0%
2001
2002
2003
Hershey's
2004
Tootsie
2005
Net Profit Analysis
Net Profit Percentage = Net Income ÷ Net Sales
5-Year Net Profit Trend Analysis
20%
17%
17%
17%
15%
13%
15%
11%
10%
5%
16%
10%
9%
5%
0%
2001
2002
2003
Hershey's
2004
Tootsie
2005
The Value of Corporate
Earnings
The
relationship between corporate earnings
and stock prices
Measured by price earnings ratio
Net Profit Percentage = Net Income ÷ Net Sales
Hershey’s = 26.69
Tootsie = 20.09
International Accounting Standards

International Accounting Standards Committee has:
1
2
3
Defined the concepts of performance and income in “Framework for the
Preparation and Presentation of Financial Statements”
Discussed the content and format of the income statement in IAS No. 1, “
Presentation of financial Statements”
Discussed some components of the income statement in an amended IAS No. 8,
now titled "Accounting Policies, Changes in Accounting Estimates and Errors"
4
Defined the concept of revenue in IAS No. 18, “Revenue”
5
Amended IAS No. 33
6
Discussed the required presentation and disclosure of a discontinued operation in
IFRS No. 5, “Non-Current Assets Held for Sale and Discontinued Operations”
IASC Definitions of Performance and Income
Profit
is used

to measure performance

or as the basis for other measures
Measurement
of income is
dependent on

the concept of capital maintenance
used by the enterprise

Physical capital maintenance

Financial capital maintenance
IASC Definitions of Performance and Income




The IASC definition of income
encompasses both revenue and
expenses
The IASC has not made the
distinction between ordinary and
nonordinary operations contained in
SFAC No. 6
A proposed standard would require a “Statement of
Non-owner Movements in Equity”
Encourages an analysis of income and expenses based
on their nature or function in the enterprise
IAS No. 1: Presentation of Financial Statements


Requires an operating/non operating separation and disclosure of the
following components of income:

Revenue

Results of operating activities

Finance costs

Income from associates and joint ventures

Taxes

Profit or loss from ordinary activities

Extraordinary items

Minority interest

Net profit or loss
FASB Staff Reaction
IAS No. 8: Accounting Policies, Changes in
Accounting Estimates and Errors

Originally, IAS No. 8
 defined the concepts of






net profit or loss from ordinary activities
extraordinary items
accounting changes
fundamental errors
Each of these income statement items was
defined and reported in a manner similar to U.S. GAAP
 with the exception of fundamental errors
The revised IAS No. 8
 does not distinguish between ordinary and extraordinary items
 eliminates the concept of fundamental errors
IAS No. 8: Accounting Policies, Changes in
Accounting Estimates and Errors
A GAAP hierarchy indicates that the following sources must
be applied in descending order of authoritativeness:
International Financial Reporting Standard, including any
appendices that form part of the Standard
Interpretations
Appendices to an IFRS that do not form part
of the Standard
Implementation guidance issued by IASB in
respect of the Standard
IAS No. 8: Accounting Policies, Changes in
Accounting Estimates and Errors

Errors
Now defined as newly discovered omissions
or misstatements of prior period financial
statements based on information that was
available when the prior financial statements
were prepared
All material errors will be accounted for
retrospectively






by restating all prior periods presented
and adjusting the opening balance of retained
earnings of the earliest prior period presented
Cumulative effect recognition in income is
prohibited
FASB Staff Reaction
IAS No. 18 - Revenue

Revenue should be recognized when:
1
2
3
4
5
The enterprise has transferred to the buyer
the significant risks and rewards of
ownership of goods
The enterprise doesn’t retain managerial
involvement or control over the goods sold
The amount can be measured reliably
It is probable that economic benefits associated with
the transaction will flow to the enterprise
The costs associated with the transaction can be
measured reliably
IAS No. 18 - Revenue



U. S. GAAP does not specifically address the issue of
revenue
If it did, there would probably be a difference because of the
IASC use of the term probable future economic benefit
FASB Staff Reaction
IAS No. 35: Discontinued Operations
The amended IAS No. 33 incorporated the following additional
disclosures and guidelines:

1.
Basic and diluted EPS must be presented for
(a) profit or loss from continuing operations and
(b) net profit or loss
…on the face of the income statement for each
class of ordinary shares, for each period
presented.
2.
Potential ordinary shares are dilutive only when their
conversion to ordinary shares would decrease EPS from
continuing operations
(IAS 33 previously used net income as the benchmark).
IAS No. 35: Discontinued Operations
3.
For contracts that may be settled in cash or
shares, now includes a rebuttable presumption
that the contract will be settled in shares.
4.
If an entity purchases (for cancellation) its own
preference shares for more than their carrying
amount, the excess (premium) should be treated
as a preferred dividend in calculating basic EPS (deducted from the
numerator of the EPS computation).
5.
Guidance is provided on how to calculate the effects of contingently
issuable shares; potential ordinary shares of subsidiaries, joint ventures,
or associates: participating securities; written put options; and purchased
put and call options.
IFRS No. 5: Non-Current Assets Held for
Sale and Discontinued Operations


SFRS No. 5 replaces IAS No. 35.
Discontinued operations
Post-tax profit
or loss of the
discontinued
operation
+
Post-tax gain or
loss recognized
on the
measurement to
fair value
-
Cost to sell or
fair value
adjustments on
the disposal of
the assets (or
disposal group)
Should be presented as a single amount on the face
of the income statement
IFRS No. 5: Non-Current Assets Held for Sale
and Discontinued Operations


Detailed disclosure of revenue, expenses, pre-tax profit or loss, and
related income taxes is required
 either in the notes or on the face
of the income statement in a
section distinct from continuing
operations.
 Such detailed disclosures must
cover both the current and all
prior periods presented in the
financial statements.
IFRS No 5 prohibits the retroactive
classification as a discontinued operation, when the discontinued
criteria are met after the balance sheet date.
Prepared by
Richard Schroeder, PhD
Kathryn Yarbrough, MBA
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