The Income Statement, Comprehensive Income, and Statement of Cash Flows

Financial Statements Overview

Financial reporting relies on three key financial statements to communicate an entity's financial performance, equity changes, and cash movements over a given period:

• Income Statement (Statement of Operations or Statement of Earnings): Reports a company's profit or loss during a particular reporting period by summarizing revenues, expenses, gains, and losses.

• Comprehensive Income (Other Comprehensive Income - OCI): Includes specific types of nonowner gains and losses that are excluded from net income and the traditional income statement.

• Statement of Cash Flows: Provides detailed information regarding cash receipts and cash payments categorized by operating, investing, and financing activities.

Income from Continuing Operations

Income from continuing operations reports the revenues, expenses, gains, and losses occurring during the reporting period that are expected to persist in future periods.

Components of Continuing Operations

• Revenues: Inflows of resources resulting from providing goods or services to customers in the normal course of business.

• Expenses: Outflows of resources or incurring of liabilities while generating revenue, representing the operational costs of providing goods and services.

• Gains and Losses: Increases or decreases in equity arising from peripheral or incidental transactions of an entity. Examples include gains or losses realized upon selling property, plant, and equipment, or investment securities for an amount differing from their recorded book value.

• Operating Items: Include revenues, cost of goods sold, and operating expenses (such as selling, general and administrative, research and development, and restructuring costs) directly associated with primary operations.

• Nonoperating Items: Relate only tangentially to primary operations. Examples include interest revenue/income, interest expense, and gains or losses on the sale of investments.

• Income Taxes: Tax expense levied on continuing operations before taxes, disclosed separately as a major line item.

Income Statement Formats

Multiple-Step Income Statement

A multiple-step income statement separately classifies items by operating and nonoperating categories and presents a series of intermediate subtotals.

Key Subtotals in Multiple-Step Presentation:

1. $\text{Gross Profit} = \text{Sales Revenue} - \text{Cost of Goods Sold}$

2. $\text{Operating Income} = \text{Gross Profit} - \text{Total Operating Expenses}$

3. $\text{Income Before Income Taxes} = \text{Operating Income} + \text{Total Other Income (Expense), Net}$

4. $\text{Income from Continuing Operations} = \text{Income Before Income Taxes} - \text{Income Tax Expense}$

5. $\text{Net Income} = \text{Income from Continuing Operations} \pm \text{Discontinued Operations (Net of Tax)}$

Comprehensive Example 1: McAllister's Manufacturing

McAllister’s Manufacturing Income Statement
(For the Years Ended December 31; $ in millions, except per share data)

• Sales revenue: $1,450.6$ ($2021$) | $1,380.0$ ($2020$)

• Cost of goods sold: $832.6$ ($2021$) | $800.4$ ($2020$)

• Gross profit: $618.0$ ($2021$) | $579.6$ ($2020$)

• Operating expenses:

  • Selling expense: $123.5$ ($2021$) | $110.5$ ($2020$)

  • General and administrative expense: $147.8$ ($2021$) | $139.1$ ($2020$)

  • Research and development expense: $55.0$ ($2021$) | $65.0$ ($2020$)

  • Restructuring costs: $125.0$ ($2021$) | $0.0$ ($2020$)

  • Total operating expenses: $451.3$ ($2021$) | $314.6$ ($2020$)

• Operating income: $166.7$ ($2021$) | $265.0$ ($2020$)

• Other income (expense):

  • Interest revenue: $12.4$ ($2021$) | $11.1$ ($2020$)

  • Interest expense: $(25.9)$ ($2021$) | $(24.8)$ ($2020$)

  • Gain on sale of investments: $18.0$ ($2021$) | $19.0$ ($2020$)

• Income from continuing operations before income taxes: $171.2$ ($2021$) | $270.3$ ($2020$)

• Income tax expense: $59.9$ ($2021$) | $94.6$ ($2020$)

• Income from continuing operations: $111.3$ ($2021$) | $175.7$ ($2020$)

• Discontinued operations:

  • Loss from operations of discontinued component (including gain on disposal in 2021 of $47): $(7.6)$ ($2021$) | $(45.7)$ ($2020$)

  • Income tax benefit: $2.0$ ($2021$) | $13.0$ ($2020$)

  • Loss on discontinued operations: $(5.6)$ ($2021$) | $(32.7)$ ($2020$)

• Net income: $105.7$ ($2021$) | $143.0$ ($2020$)

Earnings per common share—basic:

• Income from continuing operations: $\$2.14$ ($2021$) | $\$3.38$ ($2020$)

• Discontinued operations: $\$(0.11)$ ($2021$) | $\$(0.63)$ ($2020$)

• Net income: $\$2.03$ ($2021$) | $\$2.75$ ($2020$)

Earnings per common share—diluted:

• Income from continuing operations: $\$2.06$ ($2021$) | $\$3.25$ ($2020$)

• Discontinued operations: $\$(0.10)$ ($2021$) | $\$(0.61)$ ($2020$)

• Net income: $\$1.96$ ($2021$) | $\$2.64$ ($2020$)

Comprehensive Example 2: Maxwell Gear Corporation

Maxwell Gear Corporation Income Statement
(For the Year Ended December 31, 2021)

• Sales revenue: $\$573,522$

• Cost of goods sold: $\$302,371$

• Gross profit: $\$271,151$

• Operating expenses:

  • Selling expense: $\$47,341$

  • General and administrative expense: $\$24,888$

  • Research and development expense: $\$16,300$

  • Total operating expenses: $\$88,529$

• Operating Income: $\$182,622$

• Other income (expense):

  • Interest revenue: $\$5,500$

  • Gain on sale of investments: $\$26,400$

  • Interest expense: $\$(14,522)$

  • Total other income, net: $\$17,378$

• Income before income taxes: $\$200,000$

• Income tax expense: $\$50,000$

• Net income: $\$150,000$

Discontinued Operations

Discontinued operations refer to the profits or losses associated with a component of an entity that has been disposed of or is held for sale.

Reporting Criteria

Discontinued operations are reported separately when both of the following criteria are met:

1. A component of an entity or group of components has been sold, disposed of, or is classified as held for sale.

2. The disposal represents a strategic shift that has, or will have, a major effect on a company's operations and financial results.

Income Statement Presentation

Income or loss from discontinued operations is reported separately below income from continuing operations, net of tax effects.

Reporting Snippet Example:

• Income from continuing operations before income taxes: $\$1,000$

• Income tax expense (25%): $\$250$

• Income from continuing operations: $\$750$

• Income from discontinued operations: $\$150$ ($\$200$ net of $\$50$ tax expense)

• Net income: $\$900$

Accounting Changes and Errors

Accounting changes and adjustments fall into three primary categories:

1. Changes in Accounting Principle

2. Changes in Accounting Estimate

3. Changes in Reporting Entity

Corrections of errors are separate adjustments handled through prior period adjustments.

Summary Matrix of Accounting Changes and Errors

Change in Accounting Principle

• Defined as changing from one acceptable GAAP method to another.

• Mandated Changes: Follow specific transition provisions using one of three implementation approaches:

  • Retrospective approach

  • Modified retrospective approach

  • Prospective approach

• Voluntary Changes: Accounted for retrospectively by revising prior years' financial statements as if the new principle had always been in use.

Change in Accounting Estimates

• Accounted for in the period of change and future periods if the change affects both (prospective treatment).

• Not handled retrospectively and strictly not considered accounting errors.

Worked Example: Depreciation Estimate Revision (Arcadia HS)

Scenario: Arcadia HS purchased equipment for $\$510,000$ estimated to have a $10$-year useful life with a $\$10,000$ salvage value. Depreciation was recorded for $7$ years on a straight-line basis. In $2017$ (year 8), total estimated useful life was revised to $15$ years with a new salvage value of $\$5,000$.

1. Journal Entry to Correct Prior Years' Depreciation:

   • No Entry required. (Changes in estimate are treated prospectively).

2. Establish Net Book Value (NBV) at Date of Change (Dec 31, 2016):

   • Equipment Cost: $\$510,000$

   • Original Salvage Value: $\$10,000$

   • Original Depreciable Base: $\$510,000 - \$10,000 = \$500,000$

   • Annual Depreciation (Years 1–7): \frac{\500,000}{10\text{ years}} = \$50,000\text{ per year}$

   • Accumulated Depreciation after 7 years: \50,000 \times 7 = \$350,000$

   • $\text{Net Book Value (NBV)} = \$510,000 - \$350,000 = \$160,000$

3. Calculate Depreciation Expense for 2017:

   • Net Book Value at start of 2017: $\$160,000$

   • New Salvage Value: $\$5,000$

   • New Depreciable Base: $\$160,000 - \$5,000 = \$155,000$

   • Remaining Useful Life: $15\text{ years total} - 7\text{ years elapsed} = 8\text{ years remaining}$

   • 2017 Depreciation Expense: \frac{\155,000}{8\text{ years}} = \$19,375$

4. Journal Entry for 2017:

• Debit: Depreciation Expense $\$19,375$

• Credit: Accumulated Depreciation $\$19,375$

Accounting Errors and Prior Period Adjustments

Errors result from mathematical mistakes, mistakes in applying accounting principles, or oversight/misuse of facts. Correcting a material error in published statements requires a prior period adjustment.

• Journal Entry Procedure: Adjusts balance sheet accounts to correct amounts and adjusts the beginning balance of retained earnings for net income effects.

• Tax Effects: The retained earnings adjustment must be reported net of tax.

• Disclosure: A disclosure note is required detailing the impact on prior net income.

Worked Example: Overstatement Error Correction (Hillsboro Co.)

Scenario: In $2018$, Hillsboro Co. discovered that it overstated accounts receivable and sales revenue by $\$100,000$ in $2017$.

• Correction Entry (Ignoring Taxes):

  • Debit: Retained Earnings $\$100,000$

  • Credit: Accounts Receivable $\$100,000$

• Correction Entry (Assuming 20% Income Tax Rate):

  • Tax impact: \100,000 \times 20\% = \$20,000$

  • Net retained earnings reduction: \100,000 \times (1 - 0.20) = \$80,000$

  • Debit: Retained Earnings $\$80,000$

  • Debit: Income Tax Payable (or Deferred Tax Asset) $\$20,000$

  • Credit: Accounts Receivable $\$100,000$

Concept Check: Accounting Changes

• Question: Which of the following represents a change in accounting principle?

  • a) Using a journal entry to correct a misstatement in current-year financial statements

  • b) Changing inventory costing method from LIFO to average cost method

  • c) Modifying the amount of bad debt expense in accounts receivables as new information on customer insolvency is obtained

  • d) Correcting a material error in financial statements that have already been released to investors

• Answer: b. Changing from LIFO to average cost is a change from one accepted GAAP principle to another. Answer c is a change in estimate; answers a and d are corrections of errors.

Earnings per Share (EPS)

Earnings per Share (EPS) measures the amount of net income earned per common share and must be reported on the face of the income statement.

$\text{Basic EPS} = \frac{\text{Net Income} - \text{Preferred Stock Dividends}}{\text{Weighted-Average Number of Common Shares Outstanding}}$

Illustration Calculation:

Assume Net Income is $\$600,000$, Preferred Stock Dividends are $\$75,000$, and common shares outstanding were $1,000,000$ for the first 3 months and $2,000,000$ for the remaining 9 months.

$\text{Weighted-Average Shares} = 1,000,000 + 1,000,000 \times \left(\frac{9}{12}\right) = 1,750,000$

$\text{Basic EPS} = \frac{\$600,000 - \$75,000}{1,750,000} = \frac{\$525,000}{1,750,000} = \$0.30$

Diluted EPS

• Incorporates the dilutive effect of all potential common shares (e.g., convertible bonds, convertible preferred stock, stock options).

• Reflects the potential reduction in EPS that would occur if potential common shares were exercised or converted into common stock, expanding the denominator.

Comprehensive Income

Comprehensive income includes all changes in equity during a period except those resulting from investments by owners (issuing stock) and distributions to owners (paying dividends).

$\text{Comprehensive Income} = \text{Net Income} + \text{Other Comprehensive Income (OCI)}$

Other Comprehensive Income (OCI) Items

OCI items are gains and losses bypassed around the income statement directly into equity, including:

1. Net unrealized holding gains and losses on available-for-sale investment securities.

2. Gains or losses from postretirement/pension benefit plans.

3. Deferred gains or losses from derivatives.

4. Foreign currency translation adjustments.

Reporting Formats

Companies can present comprehensive income in one of two formats:

• Single Continuous Statement: A single Statement of Comprehensive Income presenting Net Income components followed directly by OCI components.

• Two Separate, Consecutive Statements: A traditional Income Statement followed immediately by a Statement of Comprehensive Income.

Comprehensive Example: AstroNova, Inc. Statements of Comprehensive Income

• Net Income: $\$4,228$ ($2017$) | $\$4,525$ ($2016$)

• Other comprehensive income, net of taxes:

  • Foreign currency translation adjustments: $\$(65)$ ($2017$) | $\$(269)$ ($2016$)

  • Unrealized gain (loss) on securities available for sale: $\$(16)$ ($2017$) | $\$(7)$ ($2016$)

  • Total other comprehensive income: $\$(81)$ ($2017$) | $\$(276)$ ($2016$)

• Comprehensive income: $\$4,147$ ($2017$) | $\$4,249$ ($2016$)

Accumulated Other Comprehensive Income (AOCI)

OCI is accumulated on a cumulative basis on the balance sheet under shareholders' equity as Accumulated Other Comprehensive Income (AOCI), analogous to how annual net income accumulates into Retained Earnings.

AstroNova, Inc. Balance Sheet Equity Snippet ($ in thousands):

• Common stock: $\$492$ ($2017$) | $\$483$ ($2016$)

• Additional paid-in capital: $\$47,524$ ($2017$) | $\$45,675$ ($2016$)

• Retained earnings: $\$44,358$ ($2017$) | $\$42,212$ ($2016$)

• Treasury stock, at cost: $\$(20,781)$ ($2017$) | $\$(20,022)$ ($2016$)

• Accumulated other comprehensive income: $\$(1,056)$ ($2017$) | $\$(975)$ ($2016$)

• Total shareholders' equity: $\$70,537$ ($2017$) | $\$67,373$ ($2016$)

Concept Check: Other Comprehensive Income

• Question: Which of the following is not an example of other comprehensive income?

  • a) Income from sales

  • b) Unrealized loss on securities available for sale

  • c) Foreign currency translation adjustments

  • d) Deferred gains from derivatives

• Answer: a. Income from sales is an operating item included in net income.

Statement of Cash Flows

The Statement of Cash Flows is required whenever a balance sheet and income statement are presented. It details cash receipts and disbursements involving cash, cash equivalents, and restricted cash.

Activity Categories

1. Operating Activities

Inflows and outflows directly related to income statement transactions (revenues and expenses).

• Cash Inflows: Cash collected from customers; interest and dividends received from investments.

• Cash Outflows: Payments for inventory purchases; operating expenses (salaries, wages, rent); interest paid on debt; income taxes paid.

• Reporting Formats:

  • Direct Method: Reports specific cash receipts and cash payments for each operating activity.

  • Indirect Method: Starts with reported Net Income and adjusts for non-cash expenses, gains/losses, and working capital changes to arrive at net cash flow from operating activities.

2. Investing Activities

Inflows and outflows related to the acquisition and disposition of long-term assets and investment securities.

• Cash Inflows: Sales of property, plant, and equipment; sales of debt or equity securities of other entities; principal collections on loans made to other entities.

• Cash Outflows: Purchase of property, plant, and equipment; purchase of debt or equity securities of other entities; loans extended to other entities.

3. Financing Activities

Inflows and outflows related to transactions with creditors and owners.

• Cash Inflows: Issuance of equity securities (common/preferred stock); issuance of debt instruments (bonds, notes, mortgages).

• Cash Outflows: Cash payments for dividends; principal redemption of debt; reacquisition of capital stock (treasury stock).

Four-Step Procedure to Prepare Statement of Cash Flows

1. Determine net cash provided by (or used in) operating activities.

2. Determine net cash provided by (or used in) investing and financing activities.

3. Determine the net change (increase or decrease) in cash during the period.

4. Reconcile the net change in cash with beginning and ending cash balances.

Case Study Example: Telemarketing Inc.

Background: On January 1, 2017, Telemarketing Inc. issued 50,000 shares of $1 par value common stock for $50,000 cash. Office space and equipment were rented. In June 2017, land was purchased for $15,000. Dividends paid were $14,000.

Comparative Balance Sheet & Income Statement Data:

• Revenues: $\$172,000$

• Operating Expenses: $\$120,000$

• Net Income: $\$39,000$ (Tax expense: $\$13,000$

• Balance Sheet Changes:

  • Cash: $\$0$ to $\$31,000$ ($\$31,000$ Increase)

  • Accounts Receivable: $\$0$ to $\$41,000$ ($\$41,000$ Increase)

  • Land: $\$0$ to $\$15,000$ ($\$15,000$ Increase)

  • Accounts Payable: $\$0$ to $\$12,000$ ($\$12,000$ Increase)

  • Common Stock: $\$0$ to $\$50,000$ ($\$50,000$ Increase)

  • Retained Earnings: $\$0$ to $\$25,000$ (\39,000\text{ Net Income} - \$14,000\text{ Dividends}$

Telemarketing Inc. Statement of Cash Flows (For Year Ended Dec 31, 2017):

• Cash flows from operating activities:

  • Net income: $\$39,000$

  • Adjustments to reconcile net income to net cash:

    • Increase in accounts receivable: $\$(41,000)$

    • Increase in accounts payable: $\$12,000$

  • Net cash provided by operating activities: $\$10,000$

• Cash flows from investing activities:

  • Purchase of land: $\$(15,000)$

  • Net cash used by investing activities: $\$(15,000)$

• Cash flows from financing activities:

  • Issuance of common stock: $\$50,000$

  • Payment of cash dividends: $\$(14,000)$

  • Net cash provided by financing activities: $\$36,000$

• Net increase in cash: $\$31,000$

• Cash at beginning of year: $\$0$

• Cash at end of year: $\$31,000$

Practice Calculations

Exercise 1: Keyser Beverage Company

• Net income: $\$40,000$ (Operating)

• Dividends paid: $\$5,000$ (Financing)

• Increase in accounts receivable: $\$10,000$ (Operating subtraction)

• Increase in accounts payable: $\$5,000$ (Operating addition)

• Purchase of equipment: $\$8,000$ (Investing)

• Depreciation expense: $\$40,000$ (Operating addition)

• Issue of notes payable: $\$20,000$ (Financing)

$\text{Net Cash Provided by Operating Activities} = \$40,000 - \$10,000 + \$5,000 + \$40,000 = \$75,000$

Exercise 2: Ames Company

• Net income: $\$151,000$

• Accounts receivable increase: $\$13,000$

• Accounts payable increase: $\$9,500$

• Depreciation expense: $\$44,000$

$\text{Net Cash Provided by Operating Activities} = \$151,000 + \$44,000 - \$13,000 + \$9,500 = \$191,500$

Exercise 3: Martinez Corporation

• Sale of land and building: $\$191,000$ (Investing inflow)

• Purchase of treasury stock: $\$40,000$ (Financing)

• Purchase of land: $\$37,000$ (Investing outflow)

• Payment of cash dividend: $\$95,000$ (Financing)

• Purchase of equipment: $\$53,000$ (Investing outflow)

• Issuance of common stock: $\$147,000$ (Financing)

• Retirement of bonds: $\$100,000$ (Financing)

$\text{Net Cash Provided by Investing Activities} = \$191,000 - \$37,000 - \$53,000 = \$101,000$

Exercise 4: Classification Solutions

• (a) Issuance of common stock $\rightarrow$ Financing activity

• (b) Purchase of land and building $\rightarrow$ Investing activity

• (c) Redemption of bonds $\rightarrow$ Financing activity

• (d) Sale of equipment $\rightarrow$ Investing activity

• (e) Depreciation of machinery $\rightarrow$ Operating activity—add to net income

• (f) Amortization of patent $\rightarrow$ Operating activity—add to net income

• (g) Issuance of bonds for plant assets $\rightarrow$ Significant noncash activity

• (h) Payment of cash dividends $\rightarrow$ Financing activity

• (i) Exchange of furniture for office equipment $\rightarrow$ Significant noncash activity

• (j) Purchase of treasury stock $\rightarrow$ Financing activity

• (k) Loss on sale of equipment $\rightarrow$ Operating activity—add to net income

• (l) Increase in accounts receivable during year $\rightarrow$ Operating activity—deduct from net income

• (m) Decrease in accounts payable during year $\rightarrow$ Operating activity—deduct from net income

Significant Noncash Activities

Significant investing and financing transactions that do not directly involve cash are omitted from the cash flow statement proper and reported in a separate narrative note or supplemental disclosure schedule.

Examples:

• Issuing common stock or bonds to purchase land or equipment.

• Converting bonds or preferred stock into common stock.

• Exchanging noncash long-lived assets.

Profitability and Activity Ratios

Financial ratios evaluate asset utilization efficiency and operational earning power.

Activity Ratios

$\text{Asset Turnover Ratio} = \frac{\text{Net Sales}}{\text{Average Total Assets}}$

$\text{Receivables Turnover Ratio} = \frac{\text{Net Sales}}{\text{Average Accounts Receivable (Net)}}$

$\text{Average Collection Period} = \frac{365}{\text{Receivables Turnover Ratio}}$

$\text{Inventory Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$

$\text{Average Days in Inventory} = \frac{365}{\text{Inventory Turnover Ratio}}$

Profitability Ratios

$\text{Profit Margin on Sales} = \frac{\text{Net Income}}{\text{Net Sales}}$

$\text{Return on Assets (ROA)} = \frac{\text{Net Income}}{\text{Average Total Assets}}$

$\text{Return on Equity (ROE)} = \frac{\text{Net Income}}{\text{Average Shareholders' Equity}}$

DuPont Framework Analysis

The DuPont framework decomposes Return on Equity into three operational drivers:

$\text{Return on Equity} = \text{Profit Margin} \times \text{Asset Turnover} \times \text{Equity Multiplier}$

$\text{Return on Equity} = \left(\frac{\text{Net Income}}{\text{Net Sales}}\right) \times \left(\frac{\text{Net Sales}}{\text{Average Total Assets}}\right) \times \left(\frac{\text{Average Total Assets}}{\text{Average Total Equity}}\right)$

• Profitability Component: Profit Margin ($\frac{\text{Net Income}}{\text{Net Sales}}$).

• Activity Component: Asset Turnover ($\frac{\text{Net Sales}}{\text{Average Total Assets}}$).

• Financial Leverage Component: Equity Multiplier ($\frac{\text{Average Total Assets}}{\text{Average Total Equity}}$).