FINANCIAL ACCOUNTING
THEORY AND ANALYSIS:
TEXT AND CASES
11TH EDITION
RICHARD G. SCHROEDER
MYRTLE W. CLARK
JACK M. CATHEY
CHAPTER 6
Financial Statements I:
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.
 Focusing on short-term, less risky, projects may have long-term
detrimental effects.
3 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
Income Statement Elements
 SFAC No. 8 indicates that the primary
focus of financial reporting is to
provide information about a
company’s performance
Income Statement Elements


Vehicle for relaying performance assessments to
investors
SFAC No. 6: defined the elements of the income
statement




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.
Determining Earnings
Change in net economic
resources
2.
Views as a measure of
effectiveness
Defining Earnings
Definition of Assets and
Liabilities
3.
VS
VS
Definition of Revenue &
Expenses
Creating deferred charges
Recognized only when
they are economic
resources or obligations
VS
Created as a result of
measuring income
Each Term Is Defined As Changes in
Assets and Liabilities
4.
Both agree on importance of income statement
5.
Population from which the elements of financial statements can be
selected
Net economic resources and to
the transactions and events
that change measurable
attributes of those net
resources
VS
Items necessary to
match revenues and
costs
Statement Format
 The preparation of the income statement
has been impacted by differences of
opinion on the definition of ongoing
operations.
 Two views:
1
2
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
Excludes prior-period
adjustments
Income From Continuing Operations
 Normal and recurring revenues and expenses
 Sustainable income
 Income tax (recurring items)
 Nonrecurring items (Each net of their tax effect)
 Discontinued operations
 Extraordinary items
 Change in accounting principle
Tootsie Roll and Hershey
 Tootsie Roll Industries and The Hershey Company
are internationally known candy manufacturers.

We will use information from the two companies’ fiscal 2007 2011 annual reports to illustrate the disclosure of information
in this and subsequent chapters.
Discontinued Operations
 Why special treatment?
 Arise from a disposal of a component of a business


Comprising operations and cash flows that can be clearly
distinguished, operationally and for financial reporting
purposes, from the rest of the entity.
Original criteria contained in APB Opinion No. 30.
 This release required the separate presentation of (1) the results of
operations of the disposed segment, and (2) gain or loss on the sale of
assets for disposed segments including any operating gains or losses
during the disposal period.
 Time of disclosure was determined by whether a gain or loss was
expected on the measurement date
 Amended by SFAS 144
SFAS No. 144 FASB ASC 360
 Changed reporting of discontinued operations:
 Unit must qualify as a component (distinguishable
assets and cash flows
 If so:
 Operations and cash flows of component must be eliminated
as a result of the transaction
 Company does not retain any significant involvement in
operations of component after disposal
 Neither Hershey or Tootsie Roll disclosed any
discontinued operations
Accounting for Discontinued Operations
Under Continuing Review
 FASB Exposure Draft
 September 2008
 Amending the Criteria for Reporting a Discontinued Operation
 IASB Exposure Draft
 Discontinued Operations
 Definitions in SFAS No. 144 and IFRS No. 5 not
convergent
 Proposed definition:
 An operating segment that has been disclosed of or is
up for sale; or
 A business that meets the criteria to be classified as
held for sale on acquisition.
Discontinued Operations FAS 2013-46
 Subsequent to the publication of this text, the FASB issued a FAS 2013-46
which changed the criteria for determining disposals to be presented as
discontinued operations.
 The new definition of a discontinued operation is a component or group of components that
has been disposed of or is classified as held for sale, together as a group in a single
transaction, and represents a strategic shift that has (or will have) a major effect on an entity's
financial results.
 A business that, upon acquisition, qualifies as held for sale will also be a discontinued
operation.
 Entities are required to disclose the operating and investing cash flows for
discontinued operations.
 For disposals of individually material components that do not qualify as discontinued
operations, the board decided to require disclosures of pre-tax profit or loss of the disposed
component and the amount attributable to the parent if there is a noncontrolling interest.
 Public entities will be required to apply the guidance in annual periods
beginning on or after December 15, 2014, and interim periods within those
annual periods.
 Nonpublic entities will be required to apply the guidance within annual
periods beginning on or after December 15, 2014, and interim periods
thereafter.
Extraordinary Items
 Original definition APB No. 9 – not expected to recur
 Problems – similar items not being classified similarly
 APB Opinion No. 30
 Unusual nature
 Infrequency of occurrence
 Problem:
 Requirements do not always separate recurring and non-recurring
items – unusual but not infrequent
 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?
Accounting Changes
 APB Opinion No. 20 originally identified
four types of accounting changes:
1. Change in an accounting principle
Occurs when an entity adopts a GAAP that differs from one previously used for
reporting purposes.
2. Change in an accounting estimate
Result from the necessary consequences of periodic presentation.
3. Change in a reporting entity
Caused by changes in reporting units, which may be the result
a.
b.
c.
Consolidations,
Changes in specific subsidiaries, or a
Change in the number of companies consolidated.
4. Errors
Not viewed as accounting changes.
Result of mistakes or oversights such as the use of incorrect accounting methods
or mathematical miscalculations.
Types of Accounting Changes
 Change in accounting principle
 How reported
 APB Opinion No 20 – Catch-up adjustment with 3 exceptions
 SFAS No 154 – Retrospective application

Change in accounting estimate


Change in accounting entity


How reported – Prospective application
How reported- Retrospective application
Errors

How reported –Prior period adjustments
Earnings Per Share
 Basic calculation
Net income - Preferred dividends
Average # of common shares outstanding


APB No. 9 – concept of residual and senior securities
APB No. 15




Simple vs. complex capital structure
Required calculation of primary and fully diluted earnings per share
 The concept of common stock equivalents
Criticism of APB No. 15 - arbitrary, complex and illogical
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
 Historical - basic
 Pro forma - diluted
 Calculation:
 Includes all potential dilutive securities
1. Options and warrants - treasury stock method
2. Written put options – reverse treasury stock method
3. Convertible securities
 “as-if-converted”
4. Contingently issuable securities
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
 Hershey has a complex capital structure and discloses basic as well
as diluted earnings per share on its income statements
 Tootsie Roll has a simple capital structures and discloses only one
earnings per share figure
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
 ASU 2011-05 allows for the disclosure of
comprehensive income
 On income statement
 On a separate statement
 Previous alternative treatment of disclosure in statement of
stockholders’ equity no longer allowed
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. (No longer allowed)
 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
PROPOSED FORMAT OF THE STATEMENT OF
COMPREHENSIVE INCOME
 Under Phase B of the financial statement presentation
project the FASB and the IASB are planning to release a
plan to recast financial statements into a new format.
 One possible result is the elimination of the current definition of
net income.
 In its place, financial statement users may find a number of profit
figures that correspond to different corporate activities.
 The rationale for the new presentation is that focusing on the net
profit number has been seen as one cause for the fraud and
stock-market excesses that characterize the past several years.
PROPOSED FORMAT OF THE STATEMENT OF
COMPREHENSIVE INCOME
 The new proposed income statement has separate
categories for the disclosure of a company’s operating
business, its financing activities, investing activities, and
tax payments.
 Each category also contains an income subtotal.
 The proposal adopts a single statement of comprehensive
income format that combines income statement elements and
components of other comprehensive income into a single
statement.
 Items of other comprehensive income are to be presented in a
separate section following the income statement elements
Proposed Format of Statement of
Comprehensive Income
 Separate categories for disclosure of
 Operating business activities
 Financing activities
 Investing activities
 Tax payments
 Subtotal for each category
 All income and expense items to be classified into operating,
investing, and financing
 Disaggregate line items by function

Function: the primary activities in which an entity is engaged
 Further disaggregate line items by nature

Nature: the economic characteristics or attributes that distinguish assets, liabilities, and income and
expense items that do not respond equally to similar economic events
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 reports segmental information for two segments:
 Domestic
 International
 Tootsie Roll reports segmental information for two
segments:
 Domestic
 International
 Neither company discloses any information about major
customers.
Persistence of Revenues
5-Year Revenue Trend Analysis
140.0%
120.0%
100.0%
122.9%
100.0%
103.8%
100.0%
100.0%
107.1%
114.6%
107.0%
104.8%
100.3%
80.0%
60.0%
40.0%
20.0%
0.0%
2007
2008
Hershey
2009
2010
Tootsie Roll
2011
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.
 Both Hershey and Tootsie Roll indicated decrease in gross profit
percentage from 2010 to 2011
Gross Profit Analysis
Gross Profit Percentage = Gross profit ÷ net sales
5-Year Gross Profit Trend Analysis
50.0%
40.0%
38.7%
33.0%
34.2%
33.9%
35.8%
32.6%
42.6%
41.6%
32.8%
31.2%
30.0%
20.0%
10.0%
0.0%
2007
2008
Hershey
2009
2010
Tootsie Roll
2011
Net Profit Analysis
Net Profit Percentage = Net Income ÷ Net Sales
5-Year Net Profit Trend Analysis
20.0%
15.0%
10.0%
5.0%
10.3%
10.4%
10.6%
10.2%
8.2%
8.3%
9.0%
7.8%
6.1%
4.3%
0.0%
2007
2008
Hershey
2009
2010
Tootsie Roll
2011
Operating Profit Percentage
Operating Profit Percentage = Operating profit ÷ Net Sales
5-Year Operating Profit Analysis
20.00
15.00
15.90
14.90
15.00
14.20 13.30
13.40
17.40
17.30
12.40
10.90
10.00
5.00
2007
2008
Hershey
2009
2010
Tootsie Roll
2011
The Value of Corporate
Earnings
The relationship between corporate earnings
and stock prices
Measured by price earnings ratio
P/E Ratio = Current market price per share ÷ EPS
Hershey
= 21.68
Tootsie Roll = 31.14
Price-Earnings Ratios
Operating Profit Percentage = Operating profit ÷ Net Sales
5-Year Price-earnings ratio Analysis
50.00
45.39
37.66
40.00
30.80
30.00
32.19
30.76
31.14
25.35
18.17
20.59
21.68
20.00
10.00
2007
2008
Hershey
2009
2010
Tootsie Roll
2011
International Accounting Standards
 In addition to release of IAS No. 33 on EPS, IASB has:
1. Defined the concepts of performance and income in “Framework for the
Preparation and Presentation of Financial Statements”
2. Discussed the content and format of the income statement in IAS No. 1, “
Presentation of financial Statements”
3. 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”
7. Issued a proposed amendment to IAS No. 1
IASB 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
IASB Definitions of Performance and Income
 The IASB definition of income
encompasses both revenue and
expenses
 The IASB 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
International Accounting Standards
 IAS No. 1
Requires income statement that includes








Revenue
Results of operations
Finance costs
Gains & losses from equity investments
Tax expense
Profits or losses from ordinary activities
Minority interest
Net profit
Does not require discontinued operations or
accounting changes to be reported separately
Does not allow items to be classified as ordinary
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
IAS No. 18 - Revenue
 Revenue should be recognized when:
1 The enterprise has transferred to the buyer
the significant risks and rewards of
ownership of goods
2 The enterprise doesn’t retain managerial
involvement or control over the goods sold
3 The amount can be measured reliably
4 It is probable that economic benefits associated with
the transaction will flow to the enterprise
5 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
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.
Proposed Amendment to IAS No.1
 Similar to the FASB’s proposed Accounting Standards
Update on the Statement of Comprehensive Income;
however, there are some differences.
 The IASB chose to title the new statement “The Statement of
Profit or Loss and other Comprehensive Income.”
 The new guidance would not change those components that are
recognized in other comprehensive income under either
accounting framework
 Additionally, the two frameworks differ on the treatment of some
of those components and total convergence not achieved.
 The Boards believe that the proposals are an important step in
enhancing comparability and providing greater transparency.
End of Chapter 6
Prepared by Kathryn Yarbrough, MBA
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