The Income Statement & The Statement of Stockholders’ Equity Chapter 11 The Income Statement & The Statement of Stockholders’ Equity

Learning Objectives Analyze a complex income statement Account for a corporation’s income tax Analyze a statement of stockholders’ equity Understand managers’ and auditors’ responsibilities for the financial statements

Income Statement Periodically Prepared to report Financial Consequences of Activities Undertaken By Accounting Entity Within a Certain Period of Time Profit More resources available at end-of-period then beginning-of-period Loss Consumed more resources by the end-of-period then it generated

Income Statement Summary of Revenues and Expenses For a Specific Period of Time Grouped by Class Sales Returns and Allowances Discounts Cost of Goods Sold Gross Margin/Profit Operating Expenses Selling Expenses Salaries Advertising Travel Telephone Supplies Depreciation Administrative Salaries Telephone Legal & Professional Supplies Depreciation – Bldg & Equip Misc. Net Income from Operations Other Interest Expense Interest Income Discontinued Operations Extraordinary Events Cumulative Effect of Change Net Income Earnings Per Share

Accounting Principles Matching Revenue Realization

Income Statement - Continuing Operations Allied Electronics Corporation Income Statement Year Ended December 31, 20x5 Sales revenue $500,000 Cost of goods sold –240,000 Gross margin $260,000 Operating expenses 181,000 Operating income $ 79,000

Income Statement - Continuing Operations Operating income $79,000 Other gains (losses): Loss on restructuring operations ( 8,000) Gain on sale of machinery 19,000 Income from continuing operations before income tax $90,000 Income tax expense 36,000 Income from continuing operations $54,000

Income Statement - Special Items Discontinued operations: $35,000, less income tax of $14,000 21,000 Income before extraordinary items and cumulative effect of change in depreciation method $75,000 Extraordinary flood loss, $20,000, less income tax savings of $8,000 (12,000) Cumulative effect of change in depreciation method, $10,000, less income tax of $4,000 6,000 Net income $69,000

Income from Continuing Operations A measure of the part of the business expected to be ongoing. Used to predict future income.

Predicting Future Profits Estimated annual income in the future Estimated value of Common Stock = Investment capitalization rate If estimated value of the company: Decision Exceeds Current market Value of the Company Buy the stock Equals Hold the stock Is less than Sell the stock

Estimated Value of Common Stock

Continuing Operations The company restructured operations at a loss of $8,000. Report as “Other” item – part of continuing operations, but falls outside of main business endeavor

Other Income Statement Items Discontinued Operations Extraordinary Gains and Losses (Extraordinary Items) Must be both infrequent seldom happening or occurring and Unusual not ordinarily encountered Cumulative Effect of a Change in Accounting Method

Discontinued Operations Segment – identifiable division of a company Sold or Closed

Extraordinary Items Unusual for the company and infrequent Losses due to natural disasters Expropriations the action of the state in taking or modifying the property rights of an individual in the exercise of its sovereignty An Exception Material gains/losses from extinguishment of debt (to be reported as extraordinary item)

Cumulative Effect of a Change in Accounting Principle From double-declining-balance (DBB) to straight-line depreciation From first-in, first-out (FIFO) to weighted-average cost for inventory Report in a special section of the income statement after extraordinary items

Average number of shares of common outstanding Earnings Per Share Net Income - Preferred dividends Earnings per share = Average number of shares of common outstanding Earnings per share is disclosed separately for: continuing operations discontinued operations (do not subtract pfd) Extraordinary items (don not subtract pfd) Cumulative effect of change in accounting method (do not subtract pfd)

Income Statement - Earnings per Share Earnings per share of common stock (20,000 shares outstanding): Income from continuous operations (54000)/20000 $2.70 Income from discontinued operations (21000/20000) 1.05 Income before extraordinary item and cumulative effect of change in depreciation method (75000/20000) $3.75 Extraordinary loss (12000/20000) (0.60) Cumulative effect of change in depreciation method (6000/20000) 0.30 Net income (69000/20000) $3.45

Earnings Per Share Effect of preferred stock Dilution preferred dividends must be paid before distributions of earnings to common stockholders. Dilution Convertible items could result in diluted eps. Diluted EPS is disclosed on the income statement.

Comprehensive Income Change in total stockholders’ equity from all sources other than from the owners of the business. Unrealized gains (losses) on available-for-sale investments Foreign-currency translation adjustments

Corporate Income Taxes Must measure Income tax expense Income tax payable Income tax expense = Income before income tax (from the income statement) X Tax Rate Income tax payable = Taxable income from the income tax return filed with the IRS X Tax Rate

Corporate Income Taxes Difference between income tax expense and income tax payable is a deferred tax liability or deferred tax asset.

Accounting for Corporate Income Taxes Suppose for 20x5, Nike, Inc., has pretax accounting income of $900 million on the income statement. Taxable income is $800 million on the company’s income tax return. The tax rate is 40%.

Accounting for Corporate Income Taxes Dec 31 Income Tax Expense ($900 x .40) 360 Income Tax Payable ($800 x .40) 320 Deferred Tax Liability 40 Recorded income tax for the year ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Accounting for Corporate Income Taxes Income statement Income before income tax $900 Income tax expense 360 Net income $540 Balance sheet Current Liabilities: Income tax payable $320 Long-term liabilities: Deferred tax liability 40* Total $360 *Assumes beginning tax liability was zero.

Retained Earnings Prior period adjustments corrections of errors that occurred in prior periods. Since the temporary accounts have been closed to retained earnings, errors from prior periods must be made to retained earnings.

Reporting a Prior-Period Adjustment CNN Corporation Statement of Retained Earnings Year Ended December 31, 2005 Retained Earnings, Dec. 31, 2004 (original) $390,000 Prior-period adjustment – debit to correct error in recording income tax expense of 2004 ( 10,000) Retained earnings, Dec. 31, 2004, adjusted $380,000 Net income for 2005 114,000 Total $494,000 Deduct: Dividends for 2005 ( 41,000) Retained earnings balance, Dec. 31, 2005 $453,000 ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Restrictions on Retained Earnings Dividends and purchases of treasury stock require payments by the corporation to its stockholders Creditors may restrict a corporation’s dividend payments and treasury stock purchases Companies report any retained earnings restrictions in notes to the financial statements

Statement of Stockholders’ Equity Reports all changes in equity for the period. Issuance of stock Net income Cash dividends Stock dividends Treasury stock transactions Accumulated other comprehensive income

Statement of Stockholders’ Equity

Responsibility for the Financial Statements Management issues a statement of responsibility with financial statements declares responsibility for financial statements and states that they conform to GAAP

Auditor Report Typically contains three paragraphs: Identifies the audited financial statements Describes how the audit was performed States the auditor’s opinion -financial statements conform to GAAP and people can rely on them for decision making

Auditor Report Unqualified (Clean) Qualified Adverse Disclaimer the financial statements presented are free of material misstatements and are in accordance with GAAP Qualified the financial statements are fairly presented with a certain exception which is otherwise misstated Adverse the information contained is materially incorrect, unreliable, and inaccurate in order to assess the auditee’s financial position and results of operations Disclaimer the auditor could not form, and consequently refuses to present, an opinion on the financial statements