Chapter 4 - Income Statement, Statement of Comprehensive Income, Statement of Stockholders' Equity

Income statement

is the report that measures the success of company operations for a given period of time

Income statement is what type of statement

a period statement (rather than a point-in-time statement)

• this means the appropriate third line of its heading should indicate some specific period of time

Major components of the income statement

• revenues

• expenses

• gains and losses

Revenues

• based on the “revenue recognition” principle: revenue should be recognized when it is “earned”, which is when it is “realized” or “realizable”

Expenses

based on the “matching” principle: expenses should be matched with the revenue that they produce and/or the time period over which the expense is incurred

Expenses, two types of costs

• product costs

• period costs

Product costs

related directly to a product; that is, the cost was incurred to get the product “ready for its intended use” and, this, this cost is expensed in the period that the product is sold

Examples of product costs for a merchandising company

• the cost of merchandise inventory

• freight-in costs related to the purchase of merchandise inventory

• also include, direct materials, direct labor and factory overhead

Period costs

not related to a specific product, but rather to a particular time period and, therefore, expensed in that period of time

Examples of period costs for a merchandising company

• “depreciation expense: building” for the period

• “salaries expense” for the period

• “rent expense” for the period

• include all of the costs incurred outside of the factory

Gain and losses

resulting from incidental or peripheral transactions

Examples of gain and losses for a merchandising company

• “gain on sale of temporary investments”

• loss on sale of machinery”

Limitations of the income statement

• it does not consider all types of income, such as certain elements of comprehensive income

• some items reported on the income statement are difficult to measure

• the amount of reported income is affect by: the accounting methods that are used and the accounting estimates and judgments that are used

• most companies try to “manage” their earnings (income smoothing) and at times, are able to do so even though there are many accounting rules that are written to limit their ability

Income statement helps evaluate

• historical profitability (confirmatory value)

• historical operating efficiency (confirmatory value)

• the possibility and probability of future profitability (predictive value)

• the possibility and probability of future cash flows (predictive value)

Notes about income statement

• the income statement can help - with the use of other financial statements - to evaluate a company’s long-term risk, its use of leverage, and its operating efficiency

• the income statement is of very little use in helping to evaluate a company’s liquidity or its financial flexibility

Computation of net income

• the transaction approach

• the capital maintenance approach (don’t need to worry about)

The transaction approach

• the normal, proper way of computing net income

• it is accomplished by making appropriate journal entries throughout the period and then preparing an income statement with the use of all income statement accounts (revenues, expenses, gain and losses)

New terms/concepts

• transparency

• quality of earnings

Transparency

financial statements that are of high quality because they are

• very clear

• easily understood

• candid

Note about transparency

many companies include account titles and/or footnote disclosures that no financial statement user could understand

Quality of earnings

earnings that are due to business operations that result in high revenues and low costs rather than earnings that are the result of

• accounting methods that were used either properly or improperly

• high inflation

• a non-recurring event like a large gain on the disposal of a segment of the business

Note about quality of earnings

a company that has a high quality of earnings has earnings that are more predictable in the future

Types of income statements

• multiple-step income statement

• single-step income statement

• other aspects of the income statement

Order of the multiple-step

Sales (operating revenues)

minus: Cost of Goods Sold

equals: Gross Profit

minus: Operating Expenses

equals: Net Operating Income

plus or minus: Other Income Other Expenses

equals: Net Income Before Taxes

minus: Income Tax Expense

equals: Net Income from Continuing Operations

plus or minus: Non-recurring Items

equals: Net Income

below net income: Earnings per Share (not in this chapter)

Operating expenses are normally classified as

• general & administrative expenses

• selling expenses

• certain gains and losses

Certain gain and losses

these are gains and losses that FASB requires to be included in the computation of “net operating income” if “net operating income” is reported

Examples of certain gains and losses

• an “loss from impairment” for any asset

• any gains or losses resulting from adjusting “assets to be disposed of” up or down to fair value

• any gain or loss resulting from the sale of assets classified as “held of disposal”

Other income - other expense criteria

non-operating but ordinary

Examples of other income - other expense

• “interest income” and “interest expense”

• gain on sale of temporary investments”

• “loss on sale of machinery”

• non-operating revenues and expenses

• “unusual items” these are gains and losses that are “unusual in nature or infrequent in occurrence” or both

• “restructuring charges”

Note about unusual items

these items

• must be reported as a separate item in “other income other expense”

• the nature and financial effects of the item must be disclosed on the income statement itself or in the footnotes

Restructuring charges

these charges often are costs incurred in restructuring (usually downsizing) the company. these coats do not qualify for “discontinued operations” reporting. these would include such items as the cost of employee buyouts, employee relocation fees, manufacturing plan closings, shifting production to a new location, or the writing off assets

Note about restructuring charges

the financial statement user must judge “unusual items” and “restructuring charges” very wisely when projecting a company’s earnings for future periods

Income tax expense

this dollar figure must be computed based on the items shown above it - those items that are included above it that are taxed at rated other than normal are called permanent differences

• “income tax expense” is not necessarily what is owed for income taxes to the IRS and the state

• taxable items shown below this must be shown at “net of tax” because of this rule

Note about income tax expense

this is called intraperiod tax allocation and results in two. items being shown at “net of tax” on the financial statements

• gain or loss from discontinued operations

• prior period adjustments

Non-recurring items

• gain or loss from discontinued operations

• extraordinary gains and losses (no longer reported on non-recurring item)

Gain or loss from discontinued operations

resulting from any gains or losses caused by the discontinuance of an identifiable component of the company

Identifiable component of a company

is a level of the company where the operations and cash flows of the component are distinguishable from the rest of the company and are reviewed by the company’s chief operating decision-maker

Gain or loss from discontinued operations, measurement criteria

measurement criteria that must be met for the segment to be considered a distinguishable component. these measurement criteria relate to the amount of revenues, identifiable assets, and/or operating profits or losses of the discontinued component

The dollar amount of this income or loss for the current period will include

• this year’s profit or loss from the operating activities of the discontinued Segment; that is, the discontinued operation’s “net sales”, “cost of goods sold”, and “operating expenses”

• any “other income-other expense” earned or incurred by this discontinued operation during the current period

• any income taxes incurred by this discontinued operation during the current period

Criteria of an extraordinary gain and loss

unusual in nature and infrequent in occurrence

Items specifically forbidden to be reported as extraordinary

• the write-down or write-off of receivables, inventory, and plant assets

• gains or losses from exchanges or translations of foreign currencies

• gains or losses resulting from a strike

• gains or losses resulting from accruals on long-term contracts

Extraordinary gains and losses are reported as

net of tax

Note about net income

for most companies in most years, “net income from continuing operations “ will be “net income” set there will be no non-recurring items

Single-step income statement

Revenues and Gains

minus: Expenses and Losses

equals: Net Income from Continuing Operations

plus or minus: Non-recurring Items

equals: Net Income

below that: Earnings per Share

Revenues and gains includes

• sales

• certain gains reported with operating expenses

• other income items

Expenses and losses includes

• cost of goods sold

• operating expenses, including certain losses included with operating expenses

• other expense items

• income tax expense

Non-recurring items

are reported on this single-step income statement in exactly the same manner as they would be reported on a multiple-step income statement

Other aspects of the income statement

• a condensed income statement

• interim financial statements

• permanent tax differences

• intraperiod tax allocation

A condensed income statement

• items on the income statement are not shown in their full detail

• both multiple-step and a single-step income statement may be prepared on a condensed basis

Examples of condensed parts

• beginning inventory, purchases, etc. are reported; only a cost of goods sold figure is reported on the income statement despite the use of a periodic inventory system

• operating expenses are not reported on an item-by-ietm basis, but rather are reported as either being selling expenses or general and administrative expenses

Interim financial statements

• many companies prepare an income statement for a period that is less than a full year

• publicly held companies are required to prepare quarterly financial statements

• these interim statements are almost never audited

Permanent tax differences

• caused by an item being included in net income before taxes that is not taxes at normal rates

• the tax on these items must be factored in when computing income tax expense

Examples of items that cause permanent tax differences

• municipal bond interest income: “interest income” reported as “other income-other expense” that is not taxable

• fines paid in violation of the law: “expenses” reported as part of “operating expenses” that are not deductible for tax purposes

• an ordinary gain or loss that is not taxed at normal rates

Intraperiod tax allocation

caused by the fact that “income tax expense” is required to be based on those income statement items that are shown above it, yet the items shown below it may also be taxable

The items that cause intraperiod tax allocation are

• gain or loss from discontinued operations

• prior period adjustments

  these items must reported on their appropriate financial statements are “net of tax”

Intraperiod tax can be calculated

• subtracting the tax effect of the item from the gross amount of the item

• also by multiplying the item by “one minus the tax rate”; that is, if the item is taxed at 40%, the “net of tax” amount of the item is the gross amount of the item times 60%

Note about net of tax and intraperiod tax allocation

the net of tax absolute value of an item is always less than the gross absolute value of the item because with a gain, more taxes are paid to the IRS, thus reducing the amount of the gain. with a loss, fewer taxes are paid to the IRS (because of the loss), thus reducing the impact of the loss

Statement of Retained Earnings

• type of statement

• format of the statement

Type of statement

• a period statement (rather than a point-in-time statement)

• therefore, the third line of the heading should indicate a specific period of time

Format of the statement of retained earnings

Beginning Retained Earnings Balance (last years ending balance)

plus or minus: Prior Period Adjustment

equals: Corrected (Adjusted) Beginning Balance of Retained Earnings

plus or minus: Net Income or Loss for the period

equals: Retained Earnings Available for Dividends

minus: Dividends Declared

equals: Ending Balance of Retained Earnings

Prior Period Adjustment

shown at “net of tax”'

the major cause of a prior period adjustment is this period’s correction of an error that occurred in a prior period that affected net income in the prior period

Items that may not be reported as a prior period adjustment

• a lawsuit loss might seem to fit the concept of a prior period adjustment since the loss normally would have occurred in a specific prior period yet be settled in the current accounting period. Lawsuits losses, however, may never be shown as a period period adjustment. They must always be reported on the current period’s income statement

• a change in an estimate made in the current period which affects amounts reported in prior periods might also seem to fit the concept of a prior period adjustment; however, estimates made in “good faith” that prove to later to be inaccurate may not be reported as a prior period adjustment

Republished financial statements

if an error occurred in a prior period and that error affected net income in that prior period and that error was corrected in the current period, there are two ways this error can be handled

How an error can be handled

• if the financial statements for the year in which the error originally occurred are not republished, a period period adjustment is reported on the earliest “statement of retained earnings” published or republished

• if the financial statements for the year in which the error originally occurred are republished, these financial statements will be corrected before republication; therefore, no prior period adjustment is reported on any “statement of retained earnings

Net income or loss for the period

• this is bottom line net income or net loss from the income statement

• this is usually shown immediately above a subtotal line entitled, “Retained Earnings Available for Dividends”, even when the entity has had a net loss for the current period

Dividend Declared

• this is the amount of dividends declared for the current period, not necessarily the amount of dividends that were paid or distributed this period

• this includes several types of dividends

  • cash dividends

  • stock dividends

  • scrip dividends

  • property dividends

Note of dividends declared

this does not include liquidating dividends which are a return of capital and which, therefore, are taken out of some “additional P-I-C” account

Ending balance of retained earnings

• this is the amount that is carried forward and shown on the balance sheet as retained earnings

• when multiple statements of retained earnings are prepared (multiple years), this is the amount carried forward from the current years to the following year

Note about the ending balance

the ending balance for one year and the beginning balance for the next year are not necessarily the balances that were originally reported because of prior period adjustments that have been made and because of revised income statements that have been prepared

Note about retained earnings #1

if retained earnings has been appropriated (put into a reserve account), this information is normally not reported in the statement of retained earnings, but rather is reported in the retained earnings section of the balance sheet

Note about retained earnings #2

some companies combine the income statement and statement of retained earnings and show it as a single financial statement with net income at the bottom of the income statement being added to the beginning retained earnings balance, which thus begins the statement of retained earnings

Other topics

• a statement of stockholders’ equity

• other comprehensive income

A statement of stockholders’ equity

• type of statement

• format of the statement

Type of statement

• a period statement (rather than a point-in-time statement)

• therefore the third line of the heading should indicate some specific period of time

Format of the statement

• a column for every stockholders’ equity account (group of accounts) as well as a column for total stockholders’ equity

• a row for each transaction occurring in the current period that affected an equity account

A column for every account

• common stock

• additional paid-in-capital

• retained earnings

• accumulated other comprehensive income

• treasury stock

• total stockerholders’ equity

A row for each transaction

• issuance of common stock

• net income

• dividends declared

• other comprehensive income for the period (even if there were seven items of other comprehensive income reported on the current period statement of comprehensive income, the company would probably report the net other comprehensive income for the current period on a single line of this statement)

• acquisition of treasury shares

Other comprehensive income

• is a “paper” gain or loss for the current period

• how other comprehensive income for the current period may be reported

• where cumulative (or accumulated) other comprehensive income as of the balance sheet date is reported

How other comprehensive income for the current period may be reported

• at the bottom of a statement of income and comprehensive income below net income where all items of other comprehensive income for the period are reported on a item-by-item basis (one-statement approach)

• on it own statement of comprehensive income

Statement of comprehensive income

• FASB call this the two-statement approach because this statement would be prepared after an income statement was prepared that computed net income

• this second statement begins with net income and all items of other comprehensive income are shown on an item-by-item basis below net income

Where cumulative other comprehensive income as of the balance sheet date is reported

• on the balance sheet

• in the stockholders’ equity section

• in the unreaalized items portion of stockholders’ equity