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- 1. Income Statement (pp. 169-198) and Statement of Cash Flows (pp.198-207) 4 Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
- 3. Page 173: Single-Step Income Statement Expenses & Losses Revenues & Gains Proper Heading
- 4. (text page 174) Multiple-Step Income Statement Non- operating Items Gross Profit Operating Expenses Proper Heading
- 6. Earnings Quality / Manipulating Income (page 175) Earnings quality: if good quality, reported earnings helps to predict a company’s future earnings. Transitory Earnings versus Permanent Earnings (examples: next slide)
- 9. Separately Reported Items (text pages 180-187) Reported separately, net of taxes: 1) Discontinued operations 2) Extraordinary items 3) A third separately reported item, the cumulative effect of a change in accounting principle, might be included for certain mandated changes in accounting principles .
- 10. Intraperiod Income Tax Allocation (text pages 180-182) Income Tax Expense must be associated with each component of income that causes it. Show Income Tax Expense related to Income from Continuing Operations. Report effects of Discontinued Operations and Extraordinary Items net of related income tax effect .
- 14. Unusual or Infrequent Items Items that are material and are either unusual or infrequent— but not both —are included as separate items in continuing operations.
- 15. Accounting Changes in: principles, estimates or entity (text pages 188-191)
- 17. Change in Depreciation, Amortization, or Depletion Method … is treated the same as a change in accounting estimate ( not as a change in principle)
- 18. Change in Accounting Estimate (review Illustr. 4-6 on page 190) If the company revises an accounting estimate made in a prior period (say, last year) …. … we use the new estimate in current and future periods That is, you do not “correct” previously reported numbers!
- 20. Correction of Accounting Errors (page 192) Errors occur when transactions are either recorded incorrectly or not recorded at all. Errors Discovered in Same Year Reverse original erroneous journal entry and record the appropriate journal entry. Record a prior period adjustment to the beginning retained earnings balance Previous years’ financial statements are retrospectively restated to reflect the correction. Material Errors Discovered in Subsequent Year
- 21. Earnings per Share Disclosure (text pages 192-193) earnings per share (EPS) shows the amount of income earned by a company expressed on a per share basis. Basic EPS Net income less preferred dividends Weighted-average number of common shares outstanding for the period Diluted EPS Reflects the potential dilution (reduction in EPS) that could occur for companies that have convertible securities that that could create additional common shares if the conversions took place.
- 23. Comprehensive Income (text pages 194-197) An expanded version of income that includes four gains and losses that are not included in the traditional income statement.
- 25. Accumulated Other Comprehensive Income We report other comprehensive income on a cumulative basis in the balance sheet as an additional component of shareholders’ equity.
- 28. Two Acceptable Methods of Reporting the Operating Activities Reports the cash effects of each operating activity Direct Method Starts with accrual net income and converts to cash basis Indirect Method
- 29. Direct Method – pages 201-202
- 30. Indirect Method (text page 203) We start with reported net income and work backwards to convert that amount to a cash basis .
- 33. ALC’s complete (3 categories) Statement of Cash Flows (page 204)
- 34. Noncash Investing & Financing Activities … . THAT DO NOT INVOLVE CASH are reported eithe r in the Cash Flow Statement or in a Note EXAMPLE: Acquisition of equipment (an investing activity) by issuing a long-term note payable (a financing activity).
- 36. End of Chapter 4
Notas del editor
- Chapter 4: The Income Statement and Statement of Cash Flows The purpose of the income statement is to summarize the profit-generating activities that occurred during a particular reporting period. The purpose of the statement of cash flows is to provide information about the cash receipts and cash disbursements of an enterprise that occurred during the period. This chapter has a twofold purpose: (1) to consider important issues dealing with income statement content, presentation, and disclosure and (2) to provide an overview of the statement of cash flows, which is covered in depth in Chapter 21.
- Before we discuss the specific components of an income statement in much depth, let’s take a quick look at the general makeup of the statement. The graphic on this slide illustrates an income statement for a hypothetical manufacturing company that you can refer to as we proceed through the chapter. At this point, our objective is only to gain a general perspective of the items reported and classifications contained in corporate income statements. Notice the three general areas include income from continuing operations, separately reported items, and earnings per share.
- No specific standards dictate how income from continuing operations must be displayed, so companies have considerable latitude in how they present the components of income from continuing operations. This flexibility has resulted in a variety of income statement presentations. However, we can identify two general approaches, the single-step and the multiple-step. This slide illustrates an example of a single step income statement for a hypothetical manufacturing company, Maxwell Gear Corporation. The single-step format first lists all the revenues and gains included in income from continuing operations. Then, expenses and losses are grouped, subtotaled, and subtracted—in a single step—from revenues and gains to derive income from continuing operations. Operating and nonoperating items are not separately classified.
- The multiple-step income statement format includes a number of intermediate subtotals before arriving at income from operations. However, notice that the net income is the same no matter which format is used. A primary advantage of the multiple-step format is that, by separately classifying operating and nonoperating items, it provides information that might be useful in analyzing trends. Similarly, the classification of expenses by function also provides useful information.
- There are more similarities than differences between income statements prepared according to U.S. GAAP and those prepared applying international standards. Some of the differences are: International standards require certain minimum information to be reported on the face of the income statement. U.S. GAAP has no minimum requirements. International standards allow expenses to be classified either by function (e.g., cost of goods sold, general and administrative, etc.), or by natural description (e.g., salaries, rent, etc.). SEC regulations require that expenses be classified by function. In the United States, the “bottom line” of the income statement usually is called either net income or net loss. The descriptive term for the bottom line of the income statement prepared according to international standards is either profit or loss. As we discuss later in the chapter, we report “extraordinary items” separately in an income statement prepared according to U.S. GAAP. International standards prohibit reporting “extraordinary items.”
- Financial analysts are concerned with more than just the bottom line of the income statement—net income. The presentation of the components of net income and the related supplemental disclosures provide clues to the user of the statement in an assessment of earnings quality. Earnings quality is used as a framework for more in-depth discussions of operating and nonoperating income. Earnings quality refers to the ability of reported earnings to predict a company’s future. The relevance of any historical-based financial statement hinges on its predictive value. To enhance predictive value, analysts try to separate a company’s transitory earnings effects from its permanent earnings. Transitory earnings effects result from transactions or events that are not likely to occur again in the foreseeable future, or that are likely to have a different impact on earnings in the future.
- Generally accepted accounting principles require that certain transactions be reported separately in the income statement, below income from continuing operations. There are two types of events that, if they have a material effect on the income statement, require separate reporting below income from continuing operations as well as separate disclosure: (1) discontinued operations and (2) extraordinary items. In fact, these are the only two events that are allowed to be reported below continuing operations. The presentation order is as shown on the slide. The objective is to separately report all the income effects of each of these items. The process of associating income tax effects with the income statement components that create them is referred to as intraperiod tax allocation, which we will address in the next section. A third separately reported item, the cumulative effect of a change in accounting principle, might be included for certain mandated changes in accounting principles. Before 2005, most voluntary changes in accounting principles also were treated this way, by including the cumulative effect on the income of previous years from having used the old method rather than the new method in the income statement of the year of change as a separately reported item below extraordinary items. Now, most voluntary changes in accounting principles require retrospective treatment. We no longer report the entire effect in the year of the change. Instead, we retrospectively recast prior years’ financial statements when we report those statements again (in comparative statements, for example) so that they appear as if the newly adopted accounting method had been used in those years presented. We discuss the retrospective approach later in this chapter and in subsequent chapters.
- Part I Intraperiod tax allocation associates (or allocates) income tax expense (or income tax benefits if there is a loss) with each major component of income that causes it. As a result, the two items reported separately below income from continuing operations are presented net of the related income tax effect. For example, assume a company experienced an extraordinary gain during the year. The amount of income tax expense deducted from income from continuing operations is the amount of income tax expense that the company would have incurred if there were no extraordinary gain. The effect on income taxes caused by the extraordinary item is deducted from the extraordinary gain in the income statement. Part II Assume that the Maxwell Gear Corporation had income from continuing operations before income tax expense of $200,000 and an extraordinary gain of $60,000 in 2011. The income tax rate is 40% on all items of income or loss. Therefore, the company’s total income tax expense is $104,000 (40% × $260,000). However, as illustrated on this slide, the total tax expense of $104,000 must be allocated, $80,000 to continuing operations and $24,000 (40% × $60,000) to the extraordinary gain.
- Extraordinary items are material events and transactions that are both unusual in nature and infrequent in occurrence and are reported net of related tax effects. These criteria must be considered in light of the environment in which the entity operates. There is obviously a considerable degree of subjectivity involved in the determination. A key point in the definition of an extraordinary item is that determining whether an event satisfies both criteria depends on the environment in which the firm operates. The environment includes factors such as the type of products or services sold and the geographical location of the firm’s operations. What is extraordinary for one firm may not be extraordinary for another firm. For example, a loss caused by a hurricane in Florida may not be judged to be extraordinary. However, hurricane damage in New York may indeed be unusual and infrequent.
- U.S. GAAP provides for the separate reporting, as an extraordinary item, of a material gain or loss that is unusual in nature and infrequent in occurrence. In 2003, the IASB revised IAS No. 1. The revision states that neither the income statement nor any notes may contain any items called “extraordinary.” A recent survey of 500 large public companies reported that only four of the companies disclosed an extraordinary gain or loss in their 2007 income statements. Losses from two 21st century “extraordinary” events, the September 11, 2001, terrorist attacks and Hurricane Katrina in 2005, did not qualify for extraordinary treatment. The treatment of these two events, the scarcity of extraordinary gains and losses reported in corporate income statements, and the desire to converge U.S. and international accounting standards could guide the FASB to the elimination of the extraordinary item classification.
- Items that are material and are either unusual or infrequent—but not both—are included as a separate item in continuing operations.
- Accounting changes fall into one of three categories: (1) a change in an accounting principle, (2) a change in an accounting estimate, or (3) a change in reporting entity. The correction of an error is another adjustment that is accounted for in the same way as certain accounting changes.
- A change in accounting principle refers to a change from one acceptable accounting method to another. There are many situations that allow alternative treatments for similar transactions. Common examples of these situations include the choice among FIFO, LIFO, and average cost for the measurement of inventory and among alternative revenue recognition methods. New standards issued by the FASB also require companies to change their accounting methods. GAAP requires that voluntary accounting changes be accounted for retrospectively. For each year in the comparative statements reported, we revise the balance of each account affected to make those statements appear as if the newly adopted accounting method had been applied all along. Then, a journal entry is created to adjust all account balances affected to what those amounts would have been. An adjustment is made to the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders’ equity to account for the cumulative income effect of changing to the new principle in periods prior to those reported. When a new FASB standard mandates a change in accounting principle, the board often allows companies to choose among multiple ways of accounting for the changes. One approach generally allowed is to account for the change retrospectively, exactly as we account for voluntary changes in principles. A second approach is to allow companies to report the cumulative effect on the income of previous years from having used the old method rather than the new method in the income statement of the year of change as a separately reported item below extraordinary items.
- A change in depreciation, amortization, or depletion method is considered to be a change in accounting estimate that is achieved by a change in accounting principle. We account for these changes prospectively, exactly as we would any other change in estimate.
- Estimates are a necessary aspect of accounting. A few of the more common accounting estimates are the amount of future bad debts on existing accounts receivable, the useful life and residual value of a depreciable asset, and future warranty expense. Because estimates require the prediction of future events, it’s not unusual for them to turn out to be wrong. When an estimate is modified as new information comes to light, accounting for the change in estimate is quite straightforward. We do not revise prior years’ financial statements to reflect the new estimate. Instead, we merely incorporate the new estimate in any related accounting determinations from that point on, that is, prospectively. Remember that a change in depreciation, amortization, or depletion method is considered a change in estimate resulting from a change in principle. For that reason, we account for such a change prospectively, similar to the way we account for other changes in estimate. One difference is that most changes in estimate do not require a company to justify the change. However, this change in estimate is a result of changing an accounting principle and therefore requires a clear justification as to why the new method is preferable.
- Part I A third type of change—the change in reporting entity —involves the preparation of financial statements for an accounting entity other than the entity that existed in the previous period. Some changes in reporting entity are a result of changes in accounting rules. For example, GAAP requires companies like Ford, General Motors and General Electric to consolidate their manufacturing operations with their financial subsidiaries, creating a new entity that includes them both. For those changes in entity, the prior-period financial statements that are presented for comparative purposes should be restated to appear as if the new entity existed in those periods. Part II However, the more frequent change in entity occurs when one company acquires another one. In those circumstances, the financial statements of the acquirer include the acquiree as of the date of acquisition, and the acquirer’s prior-period financial statements that are presented for comparative purposes are not restated. This makes it difficult to make year-to-year comparisons for a company that frequently acquires other companies. Acquiring companies are required to provide a disclosure note that presents key financial statement information as if the acquisition had occurred before the beginning of the previous year. At a minimum, the supplemental pro forma information should display revenue, income before extraordinary items, net income, and earnings per share.
- Errors occur when transactions are either recorded incorrectly or not recorded at all. Accountants employ various control mechanisms to ensure that transactions are accounted for correctly. In spite of this, errors occur. When errors do occur, they can affect any one or several of the financial statement elements on any of the financial statements a company prepares. In fact, many kinds of errors simultaneously affect more than one financial statement. When errors are discovered, they should be corrected. Most errors are discovered in the same year that they are made. These errors are simple to correct. The original erroneous journal entry is reversed and the appropriate entry is recorded. The correction of material errors discovered in a subsequent year is considered to be a prior period adjustment. A prior period adjustment refers to an addition to or reduction in the beginning retained earnings balance in a statement of shareholders’ equity (or statement of retained earnings if that’s presented instead). When it’s discovered that the ending balance of retained earnings in the period prior to the discovery of an error was incorrect as a result of that error, the balance is corrected. However, simply reporting a corrected amount might cause misunderstanding for someone familiar with the previously reported amount. Explicitly reporting a prior period adjustment on the statement of shareholders’ equity (or statement of retained earnings) avoids this confusion. In addition to reporting the prior period adjustment to retained earnings, previous years’ financial statements that are incorrect as a result of the error are retrospectively restated to reflect the correction. Also, a disclosure note communicates the impact of the error on income.
- One of the most widely used ratios is earnings per share, which shows the amount of income earned by a company expressed on a per share basis. Companies report both basic and diluted earnings per share. Basic earnings per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding. Diluted earnings per share reflects the potential for dilution that could occur for companies that have certain securities outstanding that are convertible into common shares or stock options that could create additional common shares if the options were exercised
- Companies must disclose per share amounts for (1) income or loss before any separately reported items, (2) each separately reported item, and (3) net income or loss.
- Comprehensive income is the total change in equity for a reporting period other than from transactions with owners. Comprehensive income includes net income as well as other gains and losses that change shareholders’ equity but are not included in traditional net income.
- The calculation of net income omits certain types of gains and losses that are included in comprehensive income. Companies must report both net income and comprehensive income and reconcile the difference between the two. The following items are part of comprehensive income: net unrealized holding gains (losses) from investments (net of tax). gains and losses due to revising assumptions or market returns differing from expectations and prior service cost from amending the postretirement benefit plan. when a derivative is designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction. gains or losses from changes in foreign currency exchange rates. The amount could be an addition to or reduction in shareholders’ equity. (This item is discussed elsewhere in your accounting curriculum).
- In addition to reporting OCI that occurs in the current reporting period, we must also report these amounts on a cumulative basis in the balance sheet. This is consistent with the way we report net income that occurs in the current reporting period in the income statement and also report accumulated net income (that hasn’t been distributed as dividends) in the balance sheet as retained earnings. Similarly, we report OCI as it occurs in the current reporting period and also report accumulated other comprehensive income (AOCI) in the balance sheet. This is demonstrated on this slide for Astro-Med Inc.
- The purpose of the statement of cash flows is to provide information about the cash receipts and cash disbursements of an enterprise that occurred during a period. The statement of cash flows helps investors and creditors assess future net cash flows, liquidity, and long-term solvency. A statement of cash flows is required for each income statement period reported.
- Operating activities are inflows and outflows of cash related to the transactions entering into the determination of net operating income. A few examples of cash inflows and outflows from operating activities are listed on this slide. The difference between the inflows and the outflows is called net cash flows from operating activities. This is equivalent to net income if the income statement had been prepared on a cash basis rather than an accrual basis.
- Two generally accepted formats can be used to report operating activities, the direct method and the indirect method. By the direct method, the cash effect of each operating activity is reported directly in the statement of cash flows. By the indirect method, cash flow from operating activities is derived indirectly by starting with reported net income and adding or subtracting items to convert that amount to a cash basis.
- Under the direct method, the cash effect of each operating activity is reported directly in the statement. For example, cash received from customers is reported as the cash effect of sales activities. Income statement transactions that have no cash flow effect, such as depreciation, are simply not reported. You will recall from the previous slide that ALC’s service revenue is $90,000, but ALC did not collect that much cash from its customers. We know that because accounts receivable increased from $0 to $12,000, so ALC must have collected to date only $78,000 of the amount earned. Similarly, general and administrative expenses of $32,000 were incurred, but $7,000 of that hasn’t yet been paid. We know that because accounts payable increased by $7,000. Also, prepaid insurance increased by $4,000 so ALC must have paid $4,000 more cash for insurance coverage than the amount that expired and was reported as insurance expense. That means cash paid thus far for general and administrative expenses was only $29,000 ($32,000 less the $7,000 increase in accounts payable plus the $4,000 increase in prepaid insurance). The other expense, income tax, was $15,000, but that’s the amount by which income taxes payable increased so no cash has yet been paid for income taxes.
- To report operating cash flows using the indirect method, we take a different approach. We start with ALC’s net income but realize that the $35,000 includes both cash and noncash components. We need to adjust net income, then, to eliminate the noncash effects so that we’re left with only the cash flows. We start by eliminating the only noncash component of net income in our illustration—depreciation expense. Depreciation of $8,000 was subtracted in the income statement, so we simply add it back in to eliminate it. That leaves us with the three components that do affect cash but not by the amounts reported. For those, we need to make adjustments to net income to cause it to reflect cash flows rather than accrual amounts. For instance, we saw earlier that only $78,000 cash was received from customers even though $90,000 in revenue is reflected in net income. That means we need to include an adjustment to reduce net income by $12,000, the increase in accounts receivable. In a similar manner, we include adjustments for the changes in accounts payable, income taxes payable, and prepaid insurance to cause net income to reflect cash payments rather than expenses incurred. For accounts payable and taxes payable, because more was subtracted in the income statement than cash paid for the expenses related to these two liabilities, we need to add back the differences. Note that if these liabilities had decreased, we would have subtracted, rather than added, the changes. For prepaid insurance, because less was subtracted in the income statement than cash paid, we need to subtract the difference—the increase in prepaid insurance. If this asset had decreased, we would have added, rather than subtracted, the change.
- Investing activities involve the acquisition and sale of (1) long-lived assets used in the business and (2) nonoperating investment assets. A few examples of cash inflows and outflows from investing activities are listed on this slide.
- Financing activities involve cash inflows and outflows from transactions with creditors and owners. A few examples of cash inflows and outflows from financing activities are listed on this slide.
- This slide illustrates ALC’s statement of cash flows. Earlier we showed how to arrive at net cash flows from operating activities using either the direct or indirect method. Net cash flows from investing activities represents the difference between the inflows and outflows of the investing activities. The only investing activity for ALC is the investment of $40,000 cash for equipment. We know $40,000 was paid to buy equipment because that balance sheet account increased from no balance to $40,000. Net cash flows from financing activities is the difference between the inflows and outflows of the financing activities. ACL has two financing activities. First, a review of the balance sheet indicates that common stock increased from $0 to $50,000, so we include that amount as a cash inflow from financing activities. Second, information provided with ACL’s financial statements on an earlier slide told us that $5,000 was paid as a cash dividend, which is also a financing activity.
- As we just discussed, the statement of cash flows provides useful information about the investing and financing activities in which a company is engaged. Even though these primarily result in cash inflows and cash outflows, there may be significant investing and financing activities occurring during the period that do not involve cash flows at all. In order to provide complete information about these activities, any significant noncash investing and financing activities (that is, noncash exchanges) are reported either on the face of the statement of cash flow or in a disclosure note. An example of a significant noncash investing and financing activity is the acquisition of equipment (an investing activity) by issuing either a long-term note payable or equity securities (a financing activity).
- Like U.S. GAAP, international standards also require a statement of cash flows. Consistent with U.S. GAAP, cash flows are classified as operating, investing, or financing. However, the U.S. standard designates cash outflows for interest payments and cash inflows from interest and dividends received as operating cash flows. Dividends paid to shareholders are classified as financing cash flows. IAS No. 7, on the other hand, allows more flexibility. Companies can report interest and dividends paid as either operating or financing cash flows and interest and dividends received as either operating or investing cash flows. Interest and dividend payments usually are reported as financing activities. Interest and dividends received normally are classified as investing activities.
- End of chapter 4.