Income Statement Notes

Income Statement Purpose and Discretion

• Reports results of operations for a period of time.

• Highlights material items by presenting them separately.

• Multi-step format separates operating and non-operating items.

• There is significant managerial discretion in the presentation of the income statement.

Materiality

• US GAAP definition (simplified): If omitting or misstating something would likely change a reasonable user’s decisions, it is material.

• Practical illustration: Your final grade logic

  • If the course cutoff for an A is 93 and your final is 93.5, missing 0.3 points would be material.

  • If the grade were 92.8, the 0.3 points would likely not be material.

Single-step vs Multi-step Statements

• Merck (2020) example shown as Single-step!

• Key distinction

  • Single-step: Revenues and gains are combined and total expenses, costs, and losses are subtracted to arrive at net income in a single step.

  • Multi-step: Separates operating and non-operating activities, and separates cost of goods sold from operating expenses to compute gross profit first.

Worked Practice: Multi-step Income Statement (Current Year)

Given Trial Balance

• Debit Items:

  • Cash: 10{,}800

  • Prepaid insurance: 750

  • Office supplies: 100

  • Inventory: 12{,}500

  • Cost of goods sold: 2{,}500

  • Supply expense: 400

  • Depreciation expense: 450

  • Equipment: 15{,}000

  • Accounts receivable: 2{,}000

• Credit Items:

  • Accumulated depreciation: 5{,}400

  • Revenue: 4{,}500

  • Cost of sales: 15{,}485 (as part of COGS in another format in the handout)

  • Gain from disposal of equipment: 50

  • Accounts payable: 2{,}000

  • Retained Earnings and Unearned revenue: 5{,}000 and 2{,}800

  • Insurance expense: 250 (assumed)

Tax Rate Assumption

• Tax rate for illustration: 30%

Constructed Multi-step Layout

• Revenues: 4{,}500

• Cost of goods sold: 2{,}500

• Gross profit: \text{Gross profit} = 4{,}500 - 2{,}500 = 2{,}000

• Operating expenses:

  • Supply expense: 400

  • Depreciation expense: 450

  • Insurance expense: 250

  • Total operating expenses: 400 + 450 + 250 = 1{,}100

• Income from operations: \text{Operating income} = 2{,}000 - 1{,}100 = 900

• Non-operating items:

  • Gain from disposal of equipment: 50

  • Other non-operating items: none listed

• Income before taxes: 900 + 50 = 950

• Income tax expense (30%): 0.30 \times 950 = 285

• Net income: 950 - 285 = 665

• Note: The shown balance includes additional items such as Unearned revenue and Retained Earnings; the exercise focuses on constructing the multi-step from revenue, COGS, operating expenses, non-operating income, and taxes.

Non-Operating Income and Expenses (Typical Items)

• Common items include:

  • Interest Income

  • Interest Expense

  • Gain or Loss on Sale of Assets

  • Investment Income or Loss

  • Legal Settlements (Gain or Loss)

  • Impairment Charges

  • Miscellaneous Non-Operating Income or Expense

  • Other Non-Operating Income/Expense or Gain/Loss

Unusual or Infrequent Items and Discontinued Operations

• Unusual or infrequent items are highlighted to aid earnings projection.

• Can be shown separately on the income statement or disclosed in footnotes.

• Discontinued operations (and earnings per share impact) are treated separately.

• Important concept: These items may be reclassified and presented retrospectively; prior years’ figures can be restated to reflect discontinued operations.

Discontinued Operations: Definitions and Presentation

Definitions

• Occur when a firm decides to discontinue a business unit.

• The unit can be sold, disposed of, or held for sale.

• The unit must be separable from the rest of the company.

• The disposal represents a strategic shift with a major effect on operations and financial results.

Reporting Conventions

• Always report related income or loss on a net-of-tax basis (after tax).

• For prior years, use that year’s actual effective tax rate when restating.

• Present previous years’ columns on the current income statement as if the operations had been discontinued.

• Break out EPS into continuing operations, discontinued operations, and total.

• Separate out Earnings Per Share (EPS).

Presentation Lines (Discontinued Operations)

• Line 1: Income or loss from the discontinued segment, net of tax.

• Line 2: Gain or loss on the sale of the segment, net of tax.

Disney 2020 Income Statement: Continuing vs Discontinued and Related Items

• Example structure shows revenues by services and products, and total revenues.

• Costs and expenses include cost of services, cost of products, SG&A and other, depreciation and amortization, and total costs and expenses.

• Non-operating items include restructuring and impairment charges, other income, interest expense, and equity in investees.

• In 2020, there is a line for income (loss) from discontinued operations, net of income tax benefit/expense, and a line for net income.

• Key takeaway: Discontinued ops are shown separately and after tax; continuing operations are shown before tax with their own tax line.

Restructuring Costs

• Not discontinued operations.

• Common in firms to incur restructuring costs (e.g., facility closures and layoffs).

• Reported as part of continuing operations.

• Discontinued operations involve the closure of an entire line of business, leading to a separable income stream that is not expected to recur.

• Example note: about 1,000 store closures could be sufficient to exit a line of business.

EPS: Earnings Per Share Concepts

Reporting Requirements

• Report EPS for continuing, discontinued, and all operations.

Basic EPS Formula

• \text{EPS} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Weighted Avg. number of common shares}}

EPS Components and Presentation

• EPS for continuing operations (Cont. Ops.)

• EPS for discontinued operations (Disc. Ops.)

• EPS for all operations (Total EPS) = Cont. Ops EPS + Disc. Ops EPS

Example Approach

• Income from continuing operations after tax divided by weighted average common shares gives EPS for continuing ops.

• Income from discontinued operations after tax divided by weighted average common shares gives EPS for discontinued ops.

• Break out EPS in the report accordingly.

• Worked example highlights: Company X example shows how to compute and present EPS components for 2019 and 2020, including how to treat preferred dividends and weighted average shares.

Comprehensive Income (OCI) and Balance Sheet Linkage

Comprehensive Income (CI) Equation

• CI is NI plus OCI: \text{CI} = \text{NI} + \text{OCI}

• OCI represents items not included in net income and bypass the income statement, but affect equity via accumulated other comprehensive income (AOCI).

• OCI items flow to the balance sheet via AOCI in shareholders’ equity, and CI flows ultimately to retained earnings through the equity section of the balance sheet.

Apple's OCI Components Example

• Include foreign currency translation, unrealized gains/losses on derivative instruments, and unrealized gains/losses on marketable securities, plus adjustments for gains/losses realized and included in net income.

Balance Sheet Linkage

• Beginning and ending AOCI reflect OCI movements over the period.

• Ending total shareholders’ equity equals common stock + additional paid-in capital + retained earnings + Ending AOCI + other components.

• Total liabilities and shareholders’ equity must balance with assets.

Basic Aggregation Formula on CI

• \text{CI} = \text{Net Income} + \text{OCI} \text{ (with CI feeding equity via AOCI)}

Takeaways and Practical Implications

• Knowing whether items are non-operating, unusual, or discontinued affects forecasting and valuation.

• Unusual items are presented separately on the income statement (or disclosed) and are always before tax.

• Discontinued operations are listed separately on the income statement and are always after tax.

• OCI items bypass the income statement but are included in comprehensive income (CI), which links to the balance sheet via AOCI.

Quick Practice Reference: Foothills Gear Co. Exercise (Illustrative)

Problem Setup

• 2020 pre-tax profit from all operations is 45 million, which includes a 9 million operating loss from the discontinued division, and a 6 million pre-tax gain from the sale of that division (the gain is included in the 45 million total).

• Task: Prepare a partial statement of net income starting with income from continuing operations before tax, assuming a 35% tax rate.

Approach (One Way to Solve)

• Disc pre-tax amount = -$9$ million (loss) + 6 million (gain on disposal) = -$3$ million.

• Continuing pre-tax amount = Total pre-tax profit - Disc pre-tax amount = 45 - (-3) = 48 million.

• Continuing income tax = 0.35 \times 48 = 16.8 million.

• Income from continuing operations after tax = 48 - 16.8 = 31.2 million.

• Disc ops net of tax = Disc pre-tax \times (1 - \text{tax rate}) = -3 \times (1 - 0.35) = -3 \times 0.65 = -1.95 million.

• Net income = Continuing after tax + Disc ops net of tax = 31.2 + (-1.95) = 29.25 million.

Partial Income Statement

• Continuing operations before tax: 48 million

• Income tax (35%): 16.8 million

• Income from continuing operations after tax: 31.2 million

• Discontinued operations (net of tax): -1.95 million

• Net income: 29.25 million

Quick References to Rhythm of Reporting

• Unusual/infrequent items: highlighted or footnoted; may be presented separately.

• Discontinued operations: after-tax amounts, restatements for prior years, EPS split by continuing vs discontinued.

• OCI: not part of net income but part of CI; included in AOCI on balance sheet.

• Restructuring vs discontinued: restructuring costs belong to continuing ops; discontinued ops involve exit of an entire segment.

Final Synthesis

• The income statement is a tool with multiple presentation styles and levels of detail.

• Materiality, structure (single-step vs multi-step), and the treatment of unusual items, discontinued operations, and OCI are central to how users interpret earnings quality and future prospects.

• The linkage to EPS and CI emphasizes how accounting choices affect investors’ view of profitability and equity changes over time.

Equations Referenced in Notes (LaTeX)

• Comprehensive income

  • \text{CI} = \text{NI} + \text{OCI}

• Earnings per share (basic)

  • \text{EPS} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Weighted Avg. number of common shares}}

• EPS by component

  • \text{EPS (Cont. Ops)} = \frac{\text{Income from continuing operations after tax}}{\text{Weighted Avg. common shares}}

  • \text{EPS (Disc. Ops)} = \frac{\text{Income from discontinued operations after tax}}{\text{Weighted Avg. common shares}}

• Balance sheet linkage for OCI (conceptual)

  • \text{Ending AOCI} = \text{Beginning AOCI} + \text{OCI}

• OCI items feed into CI

  • \text{CI} = \text{Net Income} + \text{OCI} \text{ (with CI feeding equity via AOCI)}