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Intermediate Accounting,17E
The Income Statement
PowerPoint presented by: Douglas Cloud
Professor Emeritus of Accounting, Pepperdine University
1
© 2010 Cengage Learning
4-1
Income Determination
The financial capital
maintenance concept assumes
that a company has income “only if
the dollar amount of an enterprise’s
net assets at the end of the period
exceeds the dollar amount of net
assets at the beginning of the
period after excluding the effects of
transactions with owners.
4-2
Financial Capital Maintenance
Kreidler, Inc. had the following assets
and liabilities at the beginning and at
the end of a period.
Beginning
of Period
Total assets
Total liabilities
Net assets
(owners’ equity)
End of
Period
$510,000
$560,000
430,000
390,000
Income is $90,000
$ 80,000
$170,000
4-3
Financial Capital Maintenance
If the owners invested $40,000 in the
business and received dividends of
$15,000, what would be the income?
Net assets, end of period
Net assets, beginning of period
Change (increase) in net assets
Deduct investment by owners
Add dividends to owners
Income
$170,000
80,000
$ 90,000
(40,000)
15,000
$ 65,000
4-4
Physical Capital Maintenance
Income per physical capital maintenance:
• Results only if production capacity at the end of
the period exceeds capacity at the beginning of
the period.
• Capacity is measured by replacement cost of net
assets.
• Income/loss is the difference between
replacement cost and net realizable value.
• Difference between historical cost and
replacement cost is considered a capital
maintenance adjustment and not part of
income.
4-5
Why is a Measure of
Income Important?
The recognition, measurement, and
reporting of business income and its
components are considered by many to
be the most important tasks of
accountants. For example:
• Has the activity been profitable?
• What is the trend of profitability?
• Is it increasing profitable, or is there a
downward trend?
4-6
Transaction Approach
To provide detail concerning the
components of income, accountants
have adopted a transaction
approach to measuring income
that stresses the direct
computation of revenues and
expenses.
4-7
4-8
Revenue and Gain Recognition
• Revenue is recognized when goods or
services have been provided and the
customer commits to payment.
• Revenues and gains are recognized
when:
1. They are realized or realizable, and
2. They have been earned through
substantial completion of the activities
involved in the earnings process.
4-9
Earlier Recognition
1. If a market exists for a product so that its
sale at an established price is practically
ensured without significant selling effort,
revenue may be recognized at the point of
completed production.
(continues)
4-10
Earlier Recognition (concl.)
2. If a product or service is contracted for in
advance, revenue may be recognized as
production takes place or as services are
performed, especially if the production or
performance period extends over more
than one fiscal year.
4-11
Later Recognition
• If payment for products or
services is considered doubtful,
revenues and gains may be
recognized as the cash is received.
• Installment sales method
• Cost recovery method
4-12
Expense and Loss Recognition
Direct Matching
Relating expenses to specific
revenues is often referred to as the
matching process. Shipping costs
and sales commissions usually relate
directly to revenues. Certain
expenses have to be estimated to be
matched against recognized revenue
for the period.
4-13
Expense and Loss Recognition
Systematic and
Rational Allocation
The cost of assets such as buildings,
equipment, patents, and prepaid
insurance are spread across the
periods of expected benefit in some
systematic and rational way.
4-14
Expense and Loss Recognition
Immediate Recognition
• Many expenses are not related to
specific revenues but are incurred to
obtain goods and services that
indirectly help to generate revenues.
• Examples include office salaries,
utilities, and general advertising. These
are recognized as expenses in the
period in which they are incurred.
4-15
Form of the Income Statement
Traditionally, the income from
continuing operations category
has been presented in multiplestep form. Using this format, the
income statement is divided into
separate sections, and various
subtotals reflect different levels of
profitability.
4-16
(continues)
4-17
(continued)
(continues)
4-18
(concluded)
4-19
Techtronics Corporation
For discussion purposes, the
multiple-step income
statement for Techtronics
Corporation will be used. This
statement is shown in Slides
4-21 and 4-22.
4-20
(continues)
4-21
4-22
Form of the Income Statement
• Comparative financial statements
present several years’ financial
statements side by side. This enables
users to analyze performance over
multiple periods and identify significant
trends.
• Consolidated financial statements
combine the financial results of the
“parent company” with other companies
that it owns, called subsidiaries.
4-23
Components of the
Income Statement
1.
2.
3.
4.
5.
6.
Revenue
Cost of goods sold
Operating expenses
Other revenues and gains
Other expenses and losses
Income taxes on continuing
operations
4-24
Income from Continuing
Operations
Determining Subtotals
Gross profit =
Revenue – Cost of goods sold
Operating income =
Gross profit – Operating expenses
4-25
Income from Continuing
Operations
Determining Subtotals
Income from continuing operations before taxes
= Operating income + Other revenues and gains
– Other expenses and losses
Income from continuing operations = Income
from continuing operations before income taxes
– Income taxes on continuing operations
4-26
Components of the
Income Statement
Revenue
Revenue reports the total
sales to customers for the
period less any sales returns
and allowances or discounts.
4-27
Components of the
Income Statement
Cost of Goods Sold
+
+
+
=
–
=
Beginning inventory
Net purchases
Freight-in
Other inventory acquisition costs
Cost of goods available for sale
Ending inventory
Cost of goods sold
4-28
Components of the
Income Statement
Cost of goods sold is a
significant item on
merchandising and
manufacturing companies’
income statements.
4-29
Components of the
Income Statement
Gross Profit
Net sales – Cost of goods sold
= Gross profit
Gross profit ÷ Net sales = Gross profit percentage
4-30
Components of the
Income Statement
Operating Expenses
Operating expenses may be
reported in two parts:
1. Selling expenses
2. General and
administrative expenses
4-31
Components of the
Income Statement
Operating Income
Operating income measures the
performance of the fundamental
business operations conducted by
a company.
Gross profit
– Operating expenses
= Operating income
4-32
Components of the
Income Statement
Other Revenues and Gains
This section usually includes
items identified with the peripheral
activities of the company.
• Rent revenue
• Interest revenue
• Dividend revenue
• Gains from the sale of assets
4-33
Components of the
Income Statement
Other Expenses and Losses
This section parallels “Other
Revenues and Gains” except the
items result in deductions from
operating income.
• Interest expense
• Losses from the sale of assets
4-34
Discontinued Operations
To report discontinued operations:
• The operations and cash flows of the
component must be clearly identifiable.
• For example, discontinued operations
would result if a company closed one of
four operating segments which tracks its
cash flows and income separately.
• The ultimate disposal must be expected
within one year of the period for which
results are being reported.
4-35
Why Discontinue?
• The component may be unprofitable.
• The component may not fit into the longrange plans for the company.
• Management may need funds to reduce
long-term debt or to expand into other
areas.
• Management may be fearful of a corporate
takeover by new investors desiring to gain
control of the company.
4-36
Discontinued Operations
According to FASB Statement No.
144, assets and liabilities
associated with discontinued
components that have not been
completely disposed of as of the
balance sheet date are to be
listed separately in the asset and
liability sections of the balance
sheet.
4-37
Discontinued Operations
In addition to the summary
income or loss amount
reported in the income
statement, the total
revenue associated with the
discontinued operations
should be disclosed in the
financial statement notes.
4-38
Extraordinary Items
Extraordinary items are events and
transactions that are both unusual in
nature and infrequent in occurrence.
Thus, they must contain “a high degree
of abnormality and be of a type clearly
unrelated to, or only incidentally related
to, the ordinary and typical activities of
the entity . . . [and] be of a type that
would not reasonable be expected to
recur in the foreseeable future. . .”¹
¹Opinions of the Accounting Principles Board No. 30, “Reporting the
Results of Operations (NY: AICPA, 1973), par. 20.
4-39
Not Extraordinary
• The write-down or write-off of receivables,
inventories, equipment leased to others, etc.
• The gains or losses from exchange or
remeasurement of foreign currencies
• The gains or losses on disposal of business
segment
• Other gains or losses from sale or
abandonment of productive assets
• The effects of a strike
• Adjustment of accruals on long-term
contracts
4-40
Changes in
Accounting Principles
Criteria for change:
1. Change in economic conditions
suggests that an accounting
change will provide better
information.
2. The FASB issues a new
pronouncement requiring a
change in principle.
4-41
Changes in
Accounting Principles
• When there is a change in accounting
principle or method, a company is
required to determine how the income
statement would have been different in
past years if the new accounting method
had been used all along.
• Income statements for all years presented
must be restated using the new
accounting method.
(continues)
4-42
Changes in
Accounting Principles
• The beginning balance of Retained
Earnings for the oldest period presented
should reflect an adjustment for the
cumulative income effect of the
accounting change on the net income of
all preceding years for which a detailed
income statement is not presented.
• Include information as if the change were
retroactive—direct and indirect effects.
4-43
Change in Estimate
Disclosure requirements include:
• Employ current and prospective approach.
• Report current and future financial
statements on new basis.
• Present prior periods as previously
reported.
• Make no adjustments to current period
opening balances.
• Present no data.
4-44
Change in Estimate
If there is both a change in
principle and a change in
estimate for an item, the
event is treated as a change
in estimate.
4-45
Effects of Changing Prices
Accountants have traditionally
ignored the effects of changing prices,
especially when gains would result
from recognition. McDonald’s used
the following approach in its 10-K
filed with the SEC.
4-46
Earnings Per Share
When presenting earnings-per-share
figures:
• Earnings per share amounts are
computed for income from
continuing operations.
• Earnings per share amounts are
calculated for each irregular or
extraordinary item.
4-47
Earnings Per Share
Earnings per share =
Income from continuing operations
Weighted average number of shares of
common stock outstanding
4-48
Price-Earnings (P/E) Ratio
The price-earnings (P/E) ratio
expresses the market value of common
stock as a multiple of earnings and
allows investors to evaluate the
attractiveness of a firm’s common stock.
Market value per share
P/E ratio =
Earnings per share
4-49
Comprehensive Income
• Comprehensive income is the number
used to reflect an overall measure of the
change in a company’s wealth during the
period.
• It includes items that arise from changes in
market conditions unrelated to the
business operations of a company.
• Most companies include a report of
comprehensive income as part of the
statement of stockholders’ equity.
4-50
Comprehensive Income
The more common adjustments made in
arriving at comprehensive income are:
• Foreign currency translation
adjustments
• Unrealized gains and losses on
available-for-sale securities
• Deferred gains and losses on
derivative financial instruments
4-51
Forecasting Future Performance
• Financial statements report the past,
but are used to predict the future.
• Key to a good forecast involves
identifying factors that determine a
certain level of revenue or expense.
• Forecasting starts with a forecast for
sales.
• Most expense forecasts are driven
from sales forecasts.
4-52
4-53