Chapter 6 The Income Statement and Measures of Performance

Chapter 6--Learning Objectives 1.Explain the different concepts of income, cash, economic, and accrual-based income measures

Concepts of Income $Cash Basis $Economic $Accrual Basis

Cash Basis Income Income = Cash inflow - Cash outflow Not reported as income under GAAP Reported in Statement of Cash Flows as net cash flow from operating activities

Economic Income Based on concept of “well-offness” Economic Income is the maximum amount that can be distributed to owners during the accounting period and leave the business as well off at the end of the accounting period as it was at the beginning of the period

Economic Income n A Capital maintenance concept of income n Income is the change in “value” of the net assets of the business during the accounting period n Measurements of assets and liabilities would be based on “fair value” at the balance sheet date, i.e., the present value of expected future cash flows

Accounting Income Accrual Basis Income n Transactions based n The change in net assets is measured utilizing historical cost (with modifications) n A financial capital maintenance concept of income

Accrual Basis Income Characteristics n Revenue recognized when earned n Expenses matched with revenue n Based on historical cost Income = Revenue + Gains - Expenses - Losses

SFAC 1 n Objectives Of Financial Reporting u To provide information F Useful in Investment & Credit Decisions F Useful in Assessing Cash Flow Prospects F About Enterprise Resources, Claims to Those Resources, & Changes in Them

SFAC 1: Enterprise Performance & Earnings n The primary focus of financial reporting n Expectations about future performance are commonly based on past performance n Accrual based earnings provide a better indication of performance than cash flows n Relate Benefits and Costs of Operations, Events & Circumstances that affect the Enterprise

Accrual Basis Accounting Income n Consistent with the concept of Financial Capital Maintenance n Income = the change in net assets occurring during the period excluding transactions with owners

Chapter 6--Learning Objectives 2.Demonstrate the format of the income statement

Income Statement n Includes the following elements of financial statements u Revenues u Expenses u Gains & Losses

Income Statement Formats n Single Step n Multiple Step

Single Step Revenues & Gains minus Expenses & Losses Including Income Taxes

Single-step income statement form Revenues: Sales revenue$XXX Interest incomeXXX Dividend revenueXXX Gain on sale of equipmentXXX Other incomeXXX Total revenueXXX

Expenses: Cost of goods soldXXX Selling & administrative expenseXXX Interest expenseXXX Loss on sale of landXXX Other expenseXXX Provision for income taxesXXX Total expensesXXX Single-step income statement form

Multiple-step income statement form Sales revenue$XXX Cost of goods soldXXX Gross profitXXX Operating expenses: Selling & administrative expenseXXX Other operating expensesXXX Operating expensesXXX Income from operationsXXX

Other revenue and gains: Interest revenueXXX Gain on sale of equipmentXXX Other expenses and losses: Loss on sale of landXXX Other expensesXXX Other revenue (expense)XXX Income before taxesXXX Provision for income taxesXXX Net IncomeXXX Multiple-step income statement form

Income statement form n Both single-step and multi-step formats are acceptable n APB Opinion No. 30 requires special presentation of: Discontinued operations Extraordinary items Cumulative effects of changes in accounting principles

Elements of the income statement Sales and operating revenues Revenues from sales less discounts, returns and allowances Cost of goods sold Beginning inventory plus purchases (net of returns & allowances but including transportation) less ending inventory Operating expenses Normally classified as administrative expenses and selling expenses

Elements of the income statement Non-operating items Revenues, expenses, gains and losses outside the normal operations of the business Provision for income taxes Includes federal, state and local income taxes Special reporting items Discontinued operations, extraordinary items and accounting changes

Chapter 6--Learning Objectives 3.Specify which circumstances qualify as special reporting items, and explain how to measure and report those special items on the income statement

Extraordinary Items APB 30 Absent discontinued operations, the following main captions should be reported in the income statement if extraordinary items are reported Income before Extraordinary ItemXXX Extraordinary Item (less applicable taxes of $____)XXX Net IncomeXXX

Net salesXXX CGSXXX Gross profitXXX Operating expensesXXX Income from operationsXXX Other…(non operating items)XXX Income before tax & extraordinary itemXXX Income taxXXX Income before extraordinary itemXXX Extraordinary item (net of tax)XXX Net incomeXXX

Extraordinary Items? APB 30 n Events and transactions that are distinguished by their unusual nature and infrequency of occurrence

Unusual Nature n Abnormal n Significantly different from ordinary and typical activities of the entity n Beyond the control of management

Unusual Nature n Primary consideration u The environment in which the entity operates F Characteristics of the industry F Geographical location F Extent of governmental regulation

Infrequent n Not reasonably expected to recur in the foreseeable future n Take into account the environment in which the entity operates n Prior occurrence provides evidence to assess the probability of recurrence

Extraordinary Items Examples n Results of a major casualty, e.g., u Earthquake n Expropriation n Prohibition under a newly enacted law or regulation

Items which are NEVER considered to be extraordinary n Write-downs of receivables and inventories n Foreign exchange gains and losses n Gains and losses from sale or abandonment of property, plant and equipment n Labor disturbances

Accounting Change APB 20 P Change in Accounting Principle P Change in Reporting Entity P Change in Estimate

Change in Accounting Principle n Changing from one generally accepted accounting principle to another n Examples: u Change from LIFO to FIFO u Change from SYD Depreciation to Straight-line

Change in Reporting Entity n When a company has investments in other entities over which it exercises significant influence or control n Change u how the investment is reported in the balance sheet and income statement n Example u Change from the equity method of accounting to consolidation

Change in Estimate n Change in “good faith” estimate n Prompted by u Environmental changes u Availability of new information n Examples u Change in estimate of useful life of building u Change in fair value of investments in “trading securities ”

Accounting Treatments for Accounting Changes n Current n Retroactive n Prospective

Current Treatment n Report Cumulative Effect in the Income Statement n Do not restate prior financial statements n Report Pro-forma Effects for u Income before extraordinary items u Net Income

Cumulative effect in income statement APB 30 Income from 0perations XXX Other…(non operating items) XXX Income before extraordinary item and cumulative effect of accounting change XXX Extraordinary item (less taxes of $____) XXX Cumulative effect of accounting change (less taxes of $_____) XXX Net income XXX

When to apply Current Treatment n Changes in Principle u Exceptions are treated retroactively n Example u Change from Straight-line Depreciation to Double Declining Balance

Retroactive Treatment n Report cumulative effect as an adjustment to the beginning balance of Retained Earnings n Restate prior financial statements n No need to report separate Pro-formas

Retroactive treatment is required for n Changes from LIFO n Changes to or from full cost method in the extractive industry n Changes to the equity method of accounting for investments in stock n Changes in accounting for long-term contracts n Changes from retirement/replacement accounting to other depreciation methods n Changes associated with an IPO of stock

Discontinued operations: APB: 30 Income from continuing operations before taxXXX Income tax expenseXXX Income from continuing operationsXXX Discontinued operations (less taxes)XXX Extraordinary Items (less taxes) Cum effect of accounting change (less taxes)XXX Net incomeXXX

Discontinued Operations: APB 30 n Separately identifiable segment which is being disposed of u A major class of business u Separately identifiable assets, liabilities, revenues, and expenses

Discontinued Operations In the Income Statement n Two components u Income (loss) from operations u Gain (loss) from disposal

Discontinued Segment Income (Loss) from Operations n Disclosed when the decision to discontinue was made after the beginning of the year n Amount of income (loss) is determined from the beginning of the year to the date the decision is made to discontinue a segment’s operations (measurement date)

Gain (loss) from disposal of segment assets n Gain (loss) during the phase-out period n Phase-out period can extend to subsequent accounting period

The Possibilities n Measurement Date & Disposal Date occur in same accounting period n Measurement Date occurs in current period, Disposal Date occurs in a subsequent accounting period

Measurement Date & Disposal Date in Same Period Beginning of year Measurement Date Disposal Date Year End Phase Out Realized Gain (Loss) AB

Disposal Date in Subsequent Period Beginning of year Measurement Date Year End 1 Year End 2 Realized Gain (Loss) AB Disposal Date C Estimated Gain (Loss)

Disposal During a Subsequent Period - Special Rules 1 A realized Loss on disposal a Increase by estimated loss b Decrease by estimated gain (but only to zero) 2 A realized Gain on disposal a Decrease by estimated loss b Do not increase by estimated gain

Chapter 6--Learning Objectives 4.Specify which circumstances qualify as prior-period adjustments, and explain how to measure, account for, and report those adjustments in the financial statements

Prior period adjustments n SFAS No. 16 specifies three types: 1.Corrections of errors 2.Adjustments involving tax loss carryforwards of purchased subsidiaries 3.Others specified by the FASB n Our focus is on the first type

Prior period adjustments Require Retroactive Treatment n Do not affect income in the year of discovery n Are NOT reported on the income statement n Adjustments are made directly to the Retained Earnings account n Adjustments are reported on the Retained Earnings statement

Prepare the statement of retained earnings Retained earnings, Jan. 1, 2000, (as previously reported)$900,000 Correction of error in depreciation expense not charged in prior periods (net of $7,000 tax)( 15,000) Retained earnings, Jan. 1, 2000, (restated)$885,000 Net income 110,000 Retained earnings, Dec 31, 2000$995,000

Chapter 6--Learning Objectives 5.Illustrate the computations and reporting requirements for earnings- per-share presentations EPS

EPS P What a share of common stock earned during the accounting period P Numerator = Income to Common Stockholders v Subtract preferred dividends P Denominator = Weighted average number of shares outstanding

Must report EPS for n Income from Continuing Operations n Discontinued Operations n Extraordinary Items n Net Income

Chapter 6--Learning Objectives 6.Understand corporate risk and profitability analysis, using the basic ratios and categories of ratios

Profitability analysis The most common measure is return on assets (ROA) calculated as follows: Net income + [(Interest expense) x (1 - Tax rate)] Average total assets

Return on assets n Measures the return on the average capital invested in assets during the accounting period. n Since both lenders and stockholders provide capital, ROA includes income before interest and its associated tax benefit.

Risk Analysis n ROA ignores the means by which operations are financed. n Also, investors are interested in the return to common stock n Hence, a frequent adjustment is to calculate the return on equity (ROE), sometimes called return on common equity (ROCE)

Return on common equity Return on assets Less:Return to creditors Less:Return to preferred shareholders Equals:Return to common shareholders or Net income - preferred dividends Average common equity