INTERMEDIATE
ACCOUNTING
CCOUNTING
INTERMEDIATE A
Chapter 5
The Income Statement and the Statement of Cash Flows
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The Importance of Earnings
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While the balance sheet represents a company’s financial
position at a moment in time, the income statement represents
its financial performance for a defined period
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The income statement reports how well the organization performed
in generating revenues, incurring expenses, and creating profits for
investors, lenders, creditors, and other stakeholders
Stock analysts (reporting to investors) develop forecasts for
quarterly and annual earnings numbers
Management faces intense pressure to generate earnings numbers
that will please investors and stakeholders and is commonly
compensated based on the company meeting or exceeding certain
earnings targets established by the board of directors
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What are the Purposes of
the Income Statement?
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Evaluate the profitability and assess the return on investment in
the company
Assess the company’s operating capability and financial
performance for the current period and over time
Evaluate management’s performance
Predict the company’s future income and cash flows
Understand the components of income
Assess the company’s risk
Compare performance against other companies
Assess the impact of economic factors on the company
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Income, Comprehensive Income, and
Net Income
• The capital maintenance concept states that a corporation’s net income for
a period of time is the amount that it could distribute to shareholders
without depleting the capital the shareholders have invested (not a return
of capital)
• Companies are required to measure and report both net income and
comprehensive income
• Comprehensive income is the change in equity of a company during a
period from transactions, other events, and circumstances relating to
nonowner sources. It includes all changes in equity during a period except
those resulting from investments by owners and distributions to owners.
• Net income measures accomplishments (resources created) and efforts
(resources used up) so that the reported net income reflects the results of the
company’s income-generating activities. In the accrual approach, a
corporation’s net income for a period is measured as follows:
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What are the Elements of
the Income Statement?
• The four elements of the income statement are
• Revenues
• Expenses
• Gains
• Losses
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Revenues
• Revenues are increases in assets or settlements of liabilities
from delivering or producing goods, rendering services, or
other activities that are the company’s ongoing major or
central operations
• They represent increases in future economic benefits from
increases in cash, accounts receivable or other types of assets,
or settlements of performance obligations to customers who
have paid in advance for goods or services
• They measure the accomplishments of the operating activities in
producing and delivering goods and services to customers
• Transactions that result in revenues are varied depending on the
company’s operations and when it can recognize revenues
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Revenue Recognition
• Revenue recognition is the process of formally measuring and
reporting revenue in a company’s financial statements
• Revenue recognition principles are a matter of timing. In
general, revenue cannot be recognized until both:
1. it has been earned
• The company has produced and delivered the goods or services to
its customers and has earned the rights to the asset being created or
has settled the liability to a customer
2.
collection has occurred or is reasonably certain to occur
• Future economic benefits associated with created assets have been
realized (received cash settling accounts receivable) or are
reasonably certain to be realized in the future
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Revenue Recognition Relative to Cash Flows
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Expenses
• Expenses arise from outflows or using up assets or incurring
liabilities (or a combination of both) from delivering or
producing goods, rendering services, or carrying out other
activities that are the company’s ongoing major or central
operations
• Within accrual accounting, expenses are measured and recognized in the
period in which the resources are used up, the outflows of assets occur, or
the liabilities are incurred, even though the cash outflows may occur in a
different period (expense recognition)
• The FASB has identified the following expense recognition
principles:
• Association of Cause and Effect
• Systematic and Rational Allocation
• Immediate Recognition
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Expenditure: Asset or Expense?
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Gains and Losses
• Gains and losses are components of net income. They are
reported “net” and generally in the period the event occurred.
• Gains are increases in the equity (net assets) of a company from
peripheral or incidental transactions… not revenue or equity
investments
• Losses are decreases in the equity (net assets) of a company from
peripheral or incidental transactions… not expenses or dividends
• Revenues and expenses relate to a company’s major operating
activities while gains and losses relate to peripheral activities
(selling fixed assets for more or less than book value) or to the
effects of other events and circumstances, some of which may
be beyond its control (e.g., loss from flood or a fire).
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What Are the Major Components of
the Income Statement?
• Although the form of the income statement may differ from company to company,
its content is relatively standard. The major components and items are:
• Revenues
• Cost of goods sold, Operating expenses, Other operating income items (gains
and losses)
• Operating income
• Interest expense, Interest and dividend income, Unusual and nonrecurring gains
and losses, Income taxes associated with continuing operations
• Income from continuing operations
• Results from discontinued operations, Income (loss) from operations of
discontinued components (net of income taxes), Gain (loss) from disposals of
discontinued components (net of income taxes)
• Extraordinary items (net of income taxes)
• Net income
• Earnings per share
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How Do Income Statements Report Operating Income
and Income from Continuing Operations?
• Operating income (loss) includes sales revenue, the various
expenses related to these sales and business activities, and
other income items related to operating activities.
• Income from continuing operations reports the company’s
income from ongoing, recurring business activities
• It includes operating income plus (or minus) income items associated
with financing and investing activities (such as interest expense and
interest income); gains and losses that are not part of normal,
ongoing operating activities; and income taxes
• It excludes the income effects of items that are not continuing, either
because they are components of the business that are being sold or
shut down or as a result from extraordinary events
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Sales Revenue
• Gross sales revenues (or gross revenues) are total increases
in assets or settlements of liabilities from delivering or
producing goods, rendering services, or other activities that
are the company’s ongoing major or central operations
• Net sales revenues (or net revenues) are the gross sales
revenues minus any sales returns or allowances and any sales
discount given to customers (or reasonably estimated)
• Net sales amounts typically exclude any sales taxes or value added taxes the
company may have collected from customers because the company will have to
remit them to the taxing authority.
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Cost of Goods Sold and Operating Expenses
• Cost of goods sold is the cost of the inventory items sold to customers
during the period.
• In a perpetual inventory system, the cost of goods sold is recorded at the
time of each sale and reports the total for the period on its income
statement
• In a periodic inventory system, the cost of goods sold is based on a
physical inventory taken at the end of each period (cost of goods
available – ending inventory)
• Operating expenses are those primary recurring costs incurred to generate
sales revenues and conduct business operations
• Typically classified according to functional categories… for example
selling expenses separated from general and administrative expenses
• Because of their significance, depreciation, amortization, research and
development expenses may also be shown as a separate categories
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Other Operating Income and Expense Items
• Gains and losses from asset sales, inventory write-downs, impairment
charges, restructuring charges, or other types of gains and losses that
are a consequence of normal operating activities are included in
operating income
• Significant recurring items of income and expense, as well as gains and
losses, which are not directly related to the primary operations but
result from the financing and investing activities
• Gains and losses that are unusual and nonrecurring “nonextraordinary”
and not a consequence of normal operating activities
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Income Taxes
• Pretax income from continuing operations is reported before income
tax expense
• Operating income plus or minus interest expense, interest and dividend income,
other gains and losses, and any unusual or nonrecurring gains and losses
• Income tax expense related to continuing operations represents an
accrued expense for the total amount of income tax (federal, state, and
foreign) that a corporation will ultimately have to pay on the income
generated during the period
• Interperiod tax allocation involves assigning a corporation’s tax
obligation as an expense across various accounting periods because of
temporary (timing) differences between its taxable income and pretax
financial income
• Intraperiod tax allocation involves apportioning a corporation’s total
income tax expense for a period to the various components of its net
income and other comprehensive income items (if any)
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Net Income Attributable to
Noncontrolling Interests
• Noncontrolling interests only arises when a parent company
owns a majority of the common shares of a subsidiary company
but does not own 100% of the shares. In a situation like this,
the parent company will consolidate 100% of the subsidiary
company’s income statement with its own income statement,
including all of the revenues, expenses, and net income of the
subsidiary. However, the noncontrolling shareholders are
entitled to a minority portion of the subsidiary’s earnings.
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How Do Income Statements Report Results from
Discontinued Operations?
• A company reports results from discontinued operations when:
• operations and cash flows of the component have been eliminated
• company will have no significant continuing involvement in the
operations of the component after the disposal
• A component of a company involves operations and cash flows
that can be distinguished, operationally and for financial
reporting purposes, from the rest of the company.
• A company must distinguish (based on management’s
judgment) the sale of a component from the sale of other
assets, as well as from other activities related to restructuring
or changing the company’s business, such as phasing out a
product line, shifting service activities, or changing the
manufacturing process.
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Operating Income (or Loss) of
a Discontinued Operation
• When a component of a company operates during part of a
year and then is sold before the end of the year, it has
operating income or an operating loss for part of the year
• This must be distinguished separately from the income from
continuing operations of the rest of the company
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Gain or Loss on Sale of a
Discontinued Operation (Slide 1 of 2)
• When the sale occurs in the same accounting period that management
decided to sell the component, the calculation of the pretax gain (loss)
is determined by subtracting the book value of the net assets (assets
minus liabilities) of the component from the net proceeds received
(selling price minus any selling costs).
• A company classifies a component as held for sale at the end of the
current accounting period when all of the following criteria are met:
• Management has committed to a plan to sell the component, the
component is available for immediate sale in its present condition,
management has begun an active program to locate a buyer, the sale is
probable within one year, the component is being offered for sale at a
price that is reasonable in relation to the component’s current fair value
and it is unlikely that management will make significant changes to the
plan
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Gain or Loss on Sale of
a Discontinued Operation
(Slide 2 of 2)
• A component classified as held for sale is reported on its balance
sheet at the lower of (1) its book value (book value of assets minus
book value of liabilities) or (2) its fair value minus any costs to sell. If
the fair value (minus any costs to sell) is less than the book value, the
company records a loss and adjusts the book values of the assets of
the component.
• The loss (after taxes) is reported in the results from discontinued
operations section of its income statement. It reports the assets and
the liabilities in the respective sections of its ending balance sheet.
• When the company actually completes the sale of a held-for-sale
component, it computes any additional gain (loss) on the sale by
subtracting the adjusted net book value of the component from the
net proceeds received.
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Disclosures
• A company is also required to disclose certain information
about the sale (or classification as held for sale) of a
discontinued component in the notes to its financial statements.
This information includes:
• a description of the facts and circumstances leading up to the sale and,
if held for sale, the expected manner and timing of the sale
• the revenues and pretax income (loss) of the component included in its
operating income (loss) reported in the results from discontinued
operations section of the company’s income statement
• if not separately reported on its income statement, the gain (loss) on the
sale and the caption on the income statement that includes the gain (loss)
• if not separately reported on its balance sheet, the book values of the
major classes of assets and liabilities
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How Do We Report Extraordinary Items
on the Income Statement?
• U.S. GAAP establishes very narrow criteria that must be met
for an event to be classified as extraordinary. IFRS do not
permit gains or losses to be labeled extraordinary.
• An extraordinary item is an event or a transaction that is
unusual in nature and infrequent in occurrence.
• Both of the following criteria must be met
• Unusual in nature—the underlying event or transaction is highly
abnormal and is clearly unrelated to, or only incidentally related to,
the ordinary and typical activities of the company, taking into
account the environment in which the company operates.
• Infrequent in occurrence—the underlying event or transaction is not
reasonably expected to recur in the foreseeable future, taking into
account the environment in which the company operates.
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Reporting Gains or Losses in Income
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How Do Companies Report
Comprehensive Income?
• Under U.S. GAAP, there are four items of other comprehensive income:
• unrealized increases (gains) or decreases (losses) in the fair value of availablefor-sale investment securities
• certain types of gains, losses, and prior service cost adjustments to net pension
plan assets and liabilities
• gains and losses on derivative financial instruments that hedge future cash flows
• translation adjustments from converting the financial statements of foreign
subsidiaries into U.S. dollars
• Under U.S. GAAP and IFRS, a company can report its comprehensive
income (or loss) under two alternatives:
• present net income and comprehensive income in a single continuous
performance statement OR
• present net income on the income statement and present comprehensive income
on a separate, but consecutive, statement of comprehensive income
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The Relationships between Shareholders’
Equity, Net Income and Comprehensive Income
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Overview and Uses of
the Statement of Cash Flows
• When used with a company’s other financial statements, the
statement of cash flows helps external users assess the
company’s:
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ability to generate positive future cash flows from operations
ability to meet its obligations
use of cash for capital expenditures and investments
capital raised from external financing sources and repayments of
external financing
• differences between the company’s net income and associated cash
receipts and payments
• sources of cash from issuing shares and uses of cash to pay dividends
and repurchase shares from common shareholders
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Reporting the Statement of Cash Flows
• Both U.S. GAAP and IFRS require that a company provide a statement of
cash flows to report on a company’s cash inflows, cash outflows, and net
change in cash from its operating, investing, and financing activities during
the accounting period, in a manner that reconciles the beginning and ending
cash balances (from the balance sheet).
• Three major sections:
• Operating activities include all the transactions and other events related to its
primary business activities, such as those involved in purchasing, producing,
selling, and delivering goods for sale, as well as providing services.
• Investing activities include transactions involving buying and selling property,
plant, and equipment and intangible assets; buying and selling long-term
investments; and lending money and collecting on the loans.
• Financing activities include transactions involved in obtaining resources from
owners and paying dividends and repurchasing shares, as well as obtaining
resources from lenders and repaying the amounts borrowed.
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Operating, Investing and Financing Activity
Cash Flows
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Operating Activities: Indirect Method
• The Operating Activities section reports the cash receipts and
payments from the operating activities of the company.
• The most common way to prepare this section is called the
indirect method.
• Net income is listed first and then adjustments (additions or
subtractions) are made:
• Reverse out the effect of certain non-cash transaction, such as
depreciation expense and amortization expense, that were included
in net income
• Include the cash flow effects triggered by changes in the period in
current assets (other than cash) and current liabilities
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Investing Activities and Financing Activities
• The Investing Activities section includes all the cash inflows
and outflows involved in the investing activities of the company
• Receipts from selling and payments for purchasing property, plant,
and equipment
• Receipts from selling and payments for purchasing investments in
stocks and debt securities
• The Financing Activities section includes all the cash inflows
and cash outflows involved in the financing activities of the
company
• Receipts from the issuance of debt securities (e.g., bonds, mortgages,
notes) and cash disbursement to repay debt obligations
• Receipts from the issuance of shares and payments to repurchase
shares (i.e., treasury stock). Payments of dividends
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Operating Activities: Direct Method
• While the FASB encourages use of the direct method, relatively few
companies use this method.
• This method separates operating cash inflows from operating cash
outflows, which may be useful in estimating future cash flows.
• The most common cash inflows and outflows for operating activities
are:
• operating cash inflows
• collections from customers
• interest and dividends collected
• operating cash outflows
• payments to suppliers and employees
• payments of interest and income taxes
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Components of Comprehensive Income
and Cash Flow (Slide 1 of 2)
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Components of Comprehensive Income
and Cash Flow (Slide 2 of 2)
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