Chapter 5: The Income Statement & the Statement of Cash Flows

purposes of the income statement

to inform investors, lenders, creditors, & other stakeholders about a company performance

capital maintenance concept

a concept under which a corporation’s net income for a period of time is the amount that it could distribute to shareholders without depleting the capital the shareholders have invested.

comprehensive income

the change in equity of a company during a period from transactions, other events, and circumstances relating to nonowner sources

net income

in accrual accounting, a company records the economic effects of transactions, events, and circumstances in the periods when they occur rather than in the periods when it receives or pays cash

elements of the income statement

revenues, expenses, gains, losses

revenues

increases in assets or settlements of liabilities from delivering or producing goods, rendering services, or other activities that are the company’s ongoing major or central operations

revenue recognition

the process of formally measuring & reporting revenue in a company’s financial statements

5 steps of revenue recognition

1. identify the contract(s) with a customer

2. identify the performance obligations in the contract

3. determine the transaction price

4. allocate the transaction price to the performance obligations in the contract

5. recognize revenue when (or as) the entity satisfies a performance obligation

expenses

arise from using up assets or incurring liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that are the company’s ongoing major or central operations

expense recognition

accrual accounting measures and recognizes expenses in the period in which the resources are used up, the outflows of assets occur, or the liabilities are incurred, even though the cash outflows may occur in a different period

3 expense recognition principles

• association of cause & effect

• systematic & rational allocation

• immediate recognition

association of cause & effect

some expenses are recognized on the basis of a direct association with specific revenues, and some transactions result simultaneously in both a revenue and an expense

systematic & rational allocation

the allocation provides a reasonable and consistent method for recognizing and matching the cost of an asset against the revenues generated during the asset’s useful life

immediate recognition

expenses are recognized in the current accounting period because the costs incurred during the period provide no present rights to economic benefits

gains

increases in the equity (net assets) of a company from transactions and other events and circumstances affecting an entity during a period, except those that result from revenues or investments by owners

losses

decreases in the equity (net assets) of a company from transactions and other events and circumstances affecting an entity during a period, except those that result from expenses or distributions to owners

3 categories of gains & losses

1. Exchange transactions in which an asset is sold or a liability settled for an amount that differs from the carrying value on the balance sheet.

2. The holding of resources or obligations while their values change

3. Nonreciprocal (i.e., “one-way”) transfers between a company and nonowners.

   
   

main components of the income statement

• revenues

• operating income

• income from continuing operations

• results from discontinued operations

• net income

• earnings per share

gross sales revenues

increases in assets or settlements of liabilities from satisfying performance obligations to customers by delivering or producing goods, performing services, or other activities that are the company’s ongoing major or central operations

net sales revenues

the gross sales revenues minus any sales discounts taken by credit customers

cost of goods sold

the cost of the inventory items sold to customers during the period

perpetual inventory system

inventory and COGS are updated at each sale

periodic inventory system

inventory is counted at the end of the period, then COGS is calculated

operating expenses

the primary recurring costs (other than the cost of goods sold) incurred to generate sales revenues and conduct business operations

operating income (loss)

the amount of sales revenue minus the cost of sales, the various operating expenses, and other income items related to operating activities

interperiod tax allocation

involves assigning a company’s tax obligation as an expense across various accounting periods because of temporary (timing) differences between its taxable income and pretax financial income

intraperiod tax allocation

involves apportioning a corporation’s total income tax expense for a period to the various components of its net income and other comprehensive income items (if any)

income from continuing operations

the company’s income from ongoing, recurring business activities

noncontrolling interests

the portion of equity and net earnings in consolidated subsidiaries that is owned by others

retained earnings

the total amount of company earnings that has not been returned to shareholders through dividends and is a major component of shareholders’ equity

statement of retained earnings

a schedule reconciles the beginning retained earnings balance with the ending retained earnings balance for smaller companies

discontinued operation

the operation arises when a company discontinues or plans to discontinue a business, a component of the business, or a group of business component

component

it involves operations and cash flows that can be distinguished, operationally and for financial reporting purposes, from the rest of the company

results from discontinued operations

this section is included on the income statement directly after income from continuing operations

earnings per share (eps)

the essential ratio in financial statement analysis is relative to the market price per share at which a stock is selling to determine the relative attractiveness of that stock

basic earnings per share

it is calculated by dividing net income available to common shareholders by weighted average number of common shares outstanding

dilutive securities

the conversion of securities to common stock would dilute the value of the outstanding common shares

diluted earnings per share

companies with dilutive securities must disclose information, taking into account the effect of these securities on the denominator and, in some instances, the numerator of the EPS ratio

5 items of other comprehensive income

unrealized gains or losses in the fair value of investments in available-for-sale debt securities

certain types of gains, losses, and prior service cost adjustments to net pension plan assets and liabilities

fair value gains or losses on the company’s issued debt for which it has elected the fair value option

fair value gains and losses on derivative financial instruments that hedge future cash flows

translation adjustments from converting the financial statements of foreign subsidiaries into U.S. dollars

2 alternatives to report comprehensive income (or loss)

present net income and comprehensive income in a single continuous performance statement

present net income on the income statement and present comprehensive income on a separate, but consecutive, statement of comprehensive income

operating

cash from normal business operations

investing

cash related to buying/selling long-term assets and investments

financing

cash related to debt and shareholders' equity

operating capability

its ability to maintain a given level of efficient operations

financial flexibility

its ability to adapt to unexpected needs and opportunities

liquidity

its ability to generate cash flows from operations and convert assets into cash

assess a company’s risk

the uncertainty and variability in the company’s future performance

statement of cash flows

a report on a company’s cash inflows, cash outflows, and net change in cash from its operating, investing, and financing activities during the accounting period, in a manner that reconciles the beginning and ending cash balances

indirect method

a net income method is first listed, and adjustments (additions or subtractions) are made

direct method

a way to present and prepare the statement of cash flows is by listing the operation cash receipts and payments from the operations section

common-size analysis

the income statements express all the amounts in terms of percentages of total revenues

gross profit margin

indicates a company’s ability to generate revenues and control the costs of producing and delivering its products and services

operating margin

indicates a company’s ability to generate a profit from its operating activities after covering all of its operating costs

net profit margin

the bottom line proportion of profit per dollar of total revenues

rate of change analysis

measures how much an item increases or decreases over time

compound rate of change

measures the average growth rate per period over multiple periods

earnings quality

a company’s earnings are relevant and faithful representations of financial performance for the current period and enable financial statement users to develop reasonable expectations of future earnings

earnings management

the earrings usually refer to the potential for companies to manipulate reported earnings within the U.S. GAAP to report higher or lower earnings

segment approach

a company that has subsidiaries prepares its financial statements on a “consolidated” basis

management approach

based on the way a company’s management organizes the company’s segments for making operating and strategic decisions and for assessing performance

operating segment

a component of an entity that engages in business activities to earn revenues and incur expenses

reportable segment

a company’s operations are significant enough that its financial activities must be reported separately

revenue test

reported revenues (including sales to external customers and intersegment sales) are 10% or more of the combined revenues of all the company’s operating segments

profit test

the absolute amount of its profit (loss) is 10% or more of the combined reported profits of all operating segments that did not report a loss

asset test

segment assets are 10% or more of the combined assets of all operating segments

overall materiality test

the reportable segments must be disclosed if their combined revenues are at least 75% of the total company’s revenues