Chapter 4 Income Statement 1. The concept of income 2. Why income measure is important 3. How income is measured 4. The format of an income statement 5. The components of an income statement 6. The comprehensive income and statement of stockholders equity 7. Simple forecasts of income for future periods 4-1
1. Define the concept of income What It Is and What It Isn t Income is not equal to the amount of cash generated from the successful operation of the business. Income is a return over and above the investment. It is the amount that an entity could return to its investors and still leave the entity as welloff at the end of the period as it was at the beginning. 4-2
Financial Capital Maintenance Concept of 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. (continued) 4-3
Financial Capital Maintenance Concept of Income Determination Kreidler, Inc. had the following assets and liabilities at the beginning and at the end of a period. Beginning of Period End of Period Total assets $510,000 $560,000 Total liabilities 430,000 390,000 Income is $90,000 Net assets (owners equity) $ 80,000 $170,000 (continued) 4-4
Financial Capital Maintenance Concept of Income Determination 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 $170,000 Net assets, beginning of period 80,000 Change (increase) in net assets $ 90,000 Deduct investment by owners (40,000) Add dividends to owners 15,000 Income $ 65,000 4-5
Physical Capital Maintenance Concept of Income Determination Income per physical capital maintenance occurs only if physical production capacity at the end of the period exceeds the physical production capacity at the beginning of the period. This concept requires that productive assets be valued at fair market value. Productive capital is maintained only if the current costs of these capital assets are maintained. 4-6
Physical Capital Maintenance Concept of Income Determination Practical Difficulties a) Difficulty in estimating depreciation lives b) Difficulty in implementing internal control procedures c) Difficulty in providing cash flow information d) Difficulty in obtaining fair market values of assets and liabilities The FASB adopted the financial capital maintenance concept as part of the conceptual framework. 4-7
2. Explain why an income measure is important Why is a Measure of Income Important? The recognition, measurement, and reporting (display) 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? 4-8
Why is a Measure of Income Important? In the United States, the FASB has specified that financial accounting information is designed with investors and creditors in mind, while at the same time recognizing that many other groups will find the resulting information useful as well. Accrual-based financial accounting information is not suited for every possible use. (continued) 4-9
Why is a Measure of Income Important? In code law countries, such as Germany and Japan, accounting standards have historically been set by legal processes. In a common law country, such as the United States and the United Kingdom, accounting standards are set in response to market forces. 4-10
2. Explain how income is measured, including the revenue recognition and expensematching concepts 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. The transaction approach, sometimes referred to as the matching method, focuses on business events that effect certain elements of the financial statements. 4-11
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Revenue and Gain Recognition Under GAAP of accrual accounting, revenue recognition does not necessarily occur when cash is received. 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. (continued) 4-13
Revenue and Gain Recognition Revenues are recognized when the company generating the revenue has provided the bulk of the goods or services it promised for the customer and when the customer has provided payment or at least a valid promise of payment to the company. In order for revenue to be recognized, inventory or other assets must be exchanged for cash or claims to cash, such as accounts receivable. 4-14
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. (continued) 4-15
Earlier Recognition 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. 4-16
Later Recognition If collectability of assets received for products or services is considered doubtful, revenues and gains may be recognized as the cash is received. The installment sales and cost recovery methods of accounting have been developed to recognize revenue under these conditions. Sales of real estate, especially speculative recreational property, are often recorded using this variation of the general rule. 4-17
Expense and Loss Recognition Direct Matching Relating expenses to specific revenues is often referred to as the matching process. For example, 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. (continued) 4-18
Expense and Loss Recognition Direct expenses include not only those that already have been incurred but also include anticipated expenses related to revenues of the current period. Costs of collection, bad debt losses from uncollectible receivables, and possible warranty costs should be estimated and matched against recognized revenue for the period. 4-19
Expense and Loss Recognition Systematic and Rational Allocation The cost of assets that benefit more than one period, such as buildings, equipment, patents, and prepaid insurance, are spread across the periods of expected benefit in some systematic and rational way. 4-20
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. 4-21
Gains and Losses from Changes in Market Values An exception to the transaction approach in the recognition of gains and losses arises when gains or loss are recognized in the wake of changes in market value. When a long-term asset, such as a building, has decreased substantially in value (an impairment), a loss is recognized even though the building has not been sold and no transaction has occurred. 4-22
4. Understand the format of an income statement Form of the Income Statement Traditionally, the income from the continuing operations category has been presented in multiple-step form. Using this format, the income statement is divided into separate sections, and various subtotals reflect different levels of profitability. (continued) 4-23
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Techtronics Corporation For discussion purposes, the multiple-step income statement for Techtronics Corporation will be used. This statement is shown in Exhibit 4-6 on Slides 4-26 and 4-27. (continued) 4-26
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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. 4-29
5. Describe the specific components of an income statement Income from Continuing Operations 1. Revenue 2. Cost of goods sold 3. Operating expenses 4. Other revenues and gains 5. Other expenses and losses 6. Income taxes on continuing operations (continued) 4-30
Income from Continuing Operations Determining Subtotals Gross profit = (Revenue Cost of goods sold) Operating income = (Gross profit Operating expenses) (continued) 4-31
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) (continued) 4-32
Income from Continuing Operations Revenue Revenue reports the total sales to customers for the period less any sales returns and allowances or discounts. Sales returns and allowances and sales discounts should be subtracted from gross sales revenue in arriving at net sales revenue. (continued) 4-33
Income from Continuing Operations 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 (continued) 4-34
Income from Continuing Operations Cost of Goods Sold Cost of goods sold is a significant item on merchandising and manufacturing companies income statements. A manufacturing company has three inventories rather than one: raw materials, goods in process, and finished goods. (continued) 4-35
Income from Continuing Operations Gross Profit Revenue from net sales Cost of goods sold = Gross profit Gross profit percentage is computed by dividing gross profit by revenue from net sales. The gross profit percentage provides a measure of profitability that allows comparisons for a firm from year to year. (continued) 4-36
Income from Continuing Operations If a company is not generating enough from the sale of a product or service to cover the costs directly associated with that product or service, the company will not be able to stay in business for long. (continued) 4-37
Income from Continuing Operations Operating Expenses Operating expenses may be reported in two parts: Selling expenses Sales salaries and commissions Related payroll taxes Advertising and store displays Store supplies used Depreciation on store furniture (continued) 4-38
Income from Continuing Operations General and administrative expenses Officers and office salaries Related payroll taxes Office supplies used Telephone, business licenses, etc. Depreciation on office furniture (continued) 4-39
Income from Continuing Operations Operating Income Operating income measures the performance of the fundamental business operations conducted by a company. Gross profit Operating expenses = Operating income (continued) 4-40
Income from Continuing Operations 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 (continued) 4-41
Income from Continuing Operations 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 (continued) 4-42
Income from Continuing Operations Income Taxes on Continuing Operations Income tax expense is the sum of all the income tax consequences of all transactions undertaken by a company during a year. The separation of income taxes into different sections of the income statement is referred to as intraperiod income tax allocation. (continued) 4-43
Income from Continuing Operations Transitory, Irregular, and Extraordinary Items These items arise from transactions and events that are not expected to continue to impact reported results in future years. Two types of transactions and events are reported in this manner: (1) discontinued operations and (2) extraordinary items. 4-44
Discontinued Operations To report discontinued operations: The operations and cash flows of the component must be clearly distinguishable from other operations and cash flows of the company, both physically and operationally, as well as for financial reporting purposes. For example, discontinued operations would result if a company closed one of five product lines in a plant which tracks its cash flows and income separately. (continued) 4-45
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. (continued) 4-46
Reporting Requirements for Discontinued Operations Thom Beard Company has two divisions, A and B. The operations and cash flows of these two divisions are clearly distinguishable, and so they both qualify as business components. On June 20, 2013, Thom Beard decides to dispose of the assets and liabilities of Division B. The revenues and expenses for Thom Beard for 2013 and for the preceding two years are shown in Slide 4-48. (continued) 4-47
Reporting Requirements for Discontinued Operations During the later part of 2013, Thom Beard disposed of a portion of Division B and recognized a pretax loss of $4,000 on the disposal. Assume a tax rate of 40%. The comparative income statements appear on Slide 4-49. (continued) 4-48
Reporting Requirements for Discontinued Operations (continued) 4-49
Discontinued Operations The reporting requirements for discontinued operations are contained in FASB ASC Subtopic 205. On the balance sheet, 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. 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. 4-50
International Accounting for Discontinued Operations According to IFRS 5, companies with discontinued operations must disclose the following: The amount of revenue, expenses, and pretax profit or loss attributed to the discontinued operations and related income tax expense. A separate disclosure of the assets, liabilities, and cash flows of the discontinued operations. (continued) 4-51
International Accounting for Discontinued Operations In complying with Financial Reporting Standard (FRS) 3 of the Accounting Standards Board in the United Kingdom, British Telecommunications provided the following information in its 2002 profit and loss account (income statement). 4-52
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 reasonably 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. (continued) 4-53
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 (continued) 4-54
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Changes in Accounting Principles The conditions of some occasions justify a change from one accounting principle to another. Occasionally a company will change an accounting principle because a change in economic conditions suggests that an accounting change will provide better information. More frequently, a change in accounting principle occurs because the FASB issues a new pronouncement requiring a change in principle. To improve compatibility, income statements for all years presented must be restated using the new accounting method. 4-56
Changes in Accounting Principles In 2013, Brandoni Company decided to change its method of computing cost of goods sold from FIFO to LIFO. The following sales and cost of goods sold information are for 2011-2013. The 2013 comparative income statements for Brandoni Company are shown below. 4-57
Changes in Estimate In reporting periodic revenues and in attempting to properly match those expenses incurred to generate current-period revenues, accountants must continually make judgments. Estimates are required for such factors as the number of years of useful life for depreciable assets, the amount of uncollectible accounts expected, and the amount of warrant liability to be recorded on the books. No retroactive adjustments. (continued) 4-58
Changes in Estimate Springville Manufacturing Co. Inc., purchased a milling machine at a cost of $100,000. It was estimated to have a useful life of 10 years and no salvage value. The company uses straight-line depreciation. At the beginning of the fifth year, conditions indicated that the machine would be used only three more years. The schedule on Slide 4-60 summarizes the charges over the life of the asset. (continued) 4-59
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Effects of Changing Prices Accountants have traditionally ignored this phenomenon, especially when gains would result from recognition. McDonald s used the following approach in its 10-K filed with the SEC. 4-61
Net Income or Loss Income or loss from continuing operations combined with the results of discontinued operations and extraordinary items provides a summary measure of the firm s performance for a period: net income or net loss. 4-62
Return on Sales In order to compare the period s results with prior periods or with the performance of other firms, net income is divided by net sales to determine the return on sales. 4-63
Earnings per share = Earnings Per Share Income from continuing operations Weighted average number of shares of common stock outstanding When presenting earnings-per-share figures: Earnings per share amounts are computed for income from continuing operations and for each unusual or extraordinary item. If necessary, companies display basic and diluted earnings per share. 4-64
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. P/E ratio = Market value per share Earnings per share (continued) 4-65
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Price-Earnings (P/E) Ratio In general, the following types of firms have higher than average P/E ratios: Firms with strong future growth possibilities Firms with earnings for the year lower than average because of a nonrecurring event Firms with substantial unrecorded assets In general, the following types of firms have lower than average P/E ratios: Firms with earnings for the year higher than average because of a nonrecurring event Firms perceived as being very risky 4-67
6. Compute comprehensive income and prepare a statement of stockholders equity. Comprehensive Income Comprehensive income is the number used to reflect an overall measure of the change in a company s wealth during the period. In addition to net income, 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. 4-68
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Comprehensive Income Three of 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 4-72
Proposed New Income Statement Format FASB and the IASB are currently engaged in a long-term project to restructure the way information is presented in the financial statements. The focus of this effort is to clearly separate financial statement items that are related to a company s business activities from items that are related to other activities such as income taxes or financing. (continued) 4-73
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7. Construct simple forecasts of income for future periods 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. It indicates how fast the company is expected to grow and represents the general volume of activity expected in the company. 4-76
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