The Income Statement & the
Statement of Stockholders’ Equity
Chapter 11
11-1
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Learning Objective 1
Analyze a corporate income statement
11-2
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Continuing Operations
• Income from day-to-day normal business
activities
• Includes:
 Revenues and operating expenses
 Gains and losses
 Income tax expense
• Can help predict future annual income
11-3
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Investment Capitalization Rate &
Value of Stock
Estimated value
of common stock
Compared to market
value of the company
# of
common X
shares
Market
price per
share
=
Estimated annual future income
Investment capitalization rate
Rate used to estimate value of stock
The higher the rate, the higher the risk
11-4
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Investment Decision Rule
If the estimated value
of the company:
Buy; stock
price may
increase
Exceeds
Current
market
value
of
the
company
Equals
Is less than
Hold; stock
price steady
Sell; stock
price may
go down
11-5
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Discontinued Operations
• Company sells a segment of the business
 Identifiable part of business
• Reported beneath income from continuing
operations
 Net of income taxes
• Not considered in predictions of future
earnings
11-6
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Extraordinary Items
• Gains and losses that are both infrequent and
unusual
• Include losses from natural disasters and
expropriation of assets by foreign governments
• Do NOT include gains or losses from lawsuits,
restructuring or sale of plant assets
• Reported after continuing operations net of
income taxes
11-7
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Cumulative Effect of Change in
Accounting Method
• Change from one accounting method to
another
 FIFO to LIFO
 Straight-line depreciation to double-declining
balance
• Makes difficult to compare year-to-year
statements
• Reported in special section usually after
extraordinary items
11-8
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Earnings per Share (EPS)
Key measure of company’s success:
Net Income - Preferred Dividends
Average number of common shares outstanding
Reported for each element of net income:
Discontinued operations, extraordinary items, etc.
Preferred dividends only subtracted for continuing
operations and net income
11-9
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Comprehensive Income
• Change in stockholders’ equity from all
non-owner transactions
• Net Income plus:
 Unrealized gains (losses) on available-forsale investments
 Foreign currency translation adjustments
• Not included in net income or EPS calculations
11-10
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E11-12
Income Statement
Year Ended December 31, 2006
Sales revenue
Operating Expenses
Operating Income before income tax
Other revenues
Income from continuing operations
before income taxes
Income tax expense
Income from continuing operations
Extraordinary gain of $1,300, less
tax of $500
Net Income
$ 104,000
97,900
$
6,100
1,800
$
$
7,900
2,800
5,100
800
5,900
11-11
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E11-12
Earnings per share (1600 shares)
Income from continuing operations
3.19
Extraordinary gain
0.50
Net Income
Divide net income
by # of shares
Income from continuing operations
Interest capitalization rate
Estimated value of Golden Book's
common stock
Divide by shares outstanding
Estimated price of one share of stock
$
$ _________
5,100
7%
72,857.14
1600
$
45.54
11-12
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Learning Objective 2
Account for a corporation’s income taxes
11-13
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Corporate Income Taxes
• Federal corporate income tax rate = 35%
• Income tax expense
 Reported on income statement
 Based on current year earnings
• Income tax payable
 Current liability on the balance sheet
 Amount to be paid to government
11-14
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Differences Between Accounting
Income and Taxable Income
• Income Statement
 Reports results of operations
 Based on accrual account
• Income Tax Return
 Filed with IRS to determine taxes owed
 Based on tax laws
• Depreciation common difference
 Straight-line for accounting purposes
 Accelerated for tax purposes
11-15
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Deferred Taxes
• When corporations use different methods
for accounting and taxes:
 Income tax expense does not equal income
tax payable
• The result is a deferred tax liability or
asset
Deferred tax
Income tax expense < Income tax payable
liability
Income tax expense > Income tax payable
Deferred
tax asset
11-16
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Prior Period Adjustments
• Correction of an accounting error from a
previous period
• Related revenue or expense item has
been closed into Retained Earnings
• Beginning retained earnings is adjusted
for the amount of the error
11-17
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Learning Objective 3
Analyze a statement of stockholders’ equity
11-18
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Statement of Stockholders’ Equity
• Includes all equity accounts (example on
following slide)
• Show activity in each account:
 From beginning balance to ending balance
 Increases and decreases
• Also includes accumulated other
comprehensive income:
 Unrealized gain or loss on investments
 Foreign currency translation adjustment
11-19
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Statement of Stockholders' Equity
Common Add'l Paidstock
in Capital
Beginning Balance
X
X
Issuance of stock
X
X
Net income
Retained
Earnings
Treasury
Stock
Total
Stockholders'
Equity
X
(X)
X
X
Which account does net income affect?
Cash dividends
Stock dividends
(X)
X
X
(X)
Purchase of treasury
stock
Sale of treasury
stock
Ending Balance
X
X
X
X
X
(X)
What’s the net effect of a stock
dividend on total equity?
(X)
(X)
X
X
(X)
X
11-20
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Learning Objective 4
Understand managers’ and auditors’
responsibilities for the financial statements
11-21
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Management’s Responsibility
• Internal controls over financial reporting in
accordance with GAAP
 Standard for preparing financial statements
 Designed to produce relevant and reliable
information for investors and creditors
11-22
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Auditor’s Report
• Companies hire Certified Public
Accountants (CPAs) to examine financial
statements
 Examination is called an external audit
 CPAs are to independent of the company they
are auditing
• CPA firms issue audit reports
 Provide opinion if financial statements are in
accordance with GAAP
11-23
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Types of Audit Reports
Unqualified
Clean opinion; Statements are fairly
presented
Qualified
“Except for” opinion; Statements are
reliable except for one or more items
Adverse
Statements are unreliable and not in
accordance with GAAP
Disclaimer
No opinion; auditor was unable to form
an opinion
11-24
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End of Chapter 11
11-25
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