Chapter 4 Statement of Income and Retained Earning Retained Earning

Importance and Limitations of Income ä Importance of Income ä Used by investors to predict the amount, timing, and uncertainty of future cash flow ä Limitations of Income ä Omits some economic income ä Affected by accounting methods used. The quality of earning may be dubious.

Income Measurement ä Capital Maintenance Vs. Transactions Approach NI = ending assets - beginning assets NI = ending assets - beginning assets or NI = revenues -expenses ? ä All Inclusive vs. Current Operating Performance NI = all gains or losses, operating or not NI = all gains or losses, operating or not or NI = regular operating income ? ä FASB is moving toward Comprehensive Income

Comprehensive Income ä Any increase and decrease in stockholders equity other than from investment from or distribution to shareholders ä Includes all items from the statement of income and other gains or losses bypassing the income statement but reflected in the changes in stockholder’s equity (called Other Comprehensive Income, e.g., unrealized holding gain or loss from available for sale securities)

Single-step Statement of Income ä All revenues $ XX ä All expenses (XX) ä Income before income taxes XX ä Income taxes (XX) ä Special items (DEC, net of taxes) XX ä Net Income XX ä EPS disclosure XX

Multiple-step Statement of Income ä Operating Revenue $XX ä Operating Expenses (XX) ä Income from operation XX ä Other Gains or Losses XX ä Income before income taxes XX ä Income taxes (XX) ä Special items (DEC, net of taxes) XX ä Net Income XX

Combined Statement of Comprehensive Income (CI) ä Combined Statement of CI ä Operating Revenues ä Operating Expenses ä Other Gains and Losses ä Special Items (DEC) ä Net Income ä Other Comprehensive Income ä Comprehensive Income

Comprehensive income Statement Net Income Other Comprehensive Income Unrealized holding gain Prior period adjustment Prior period adjustment Gains or losses from translation of foreign subsidiary’s financial statement Gains or losses from translation of foreign subsidiary’s financial statement Comprehensive Income

Statement of Retained Earning and Stockholders’ Equity Beginning Balance Comprehensive Income Net income Other comprehensive income Unrealized Holding gain Prior period adjustment Dividend Declared Ending Balances

Special Items (DEC) ä Discontinued Operations (APB #30) ä Income or loss from discontinued operation ä Gain or loss on disposal of segment ä Extraordinary Items (APB Opinion #30) ä Cumulative Effect on prior years of retroactive application of accounting change (APB Opinion #20) ä DEC are reported net of taxes

Discontinued Operation ä Definition and Criteria ä Disposal of a segment of entire line of business or class of customer ä Qualifying Examples ä Sears sold its financial brokerage operation ä Food Co. stops sale to supermarket chains ä Nonqualifying Examples ä Phasing out a product line, shifting location

Discontinued Operation-- Reporting Income Statement Income Statement Income from Continuing Operation XXX Discontinued Operation: Income or loss from operation of the Income or loss from operation of the segment up to the measurement date* XXX segment up to the measurement date* XXX All income, gains, and losses, expected or realized, from operation or from disposal, All income, gains, and losses, expected or realized, from operation or from disposal, after the measurement date XXX after the measurement date XXX *Measurement date = formal decision date

Timing of Recognition for Gains or Losses from Disposal ä If all gains and losses after the measure date result in a net loss, report the net loss during the period of measurement date (accelerates loss recognition based on conservatism) ä If the total is a net gain, the gain can only be recognized as it is realized

Discontinued Operation-- Illustration ä On May 1, ‘96, X decided to sell a segment of business. The following are relevant facts pertaining to the discontinued segment: Operating income 1/1-4/30/ $2M Operating income 5/1-12/31/ M Expected operating loss 1/1-3/ (1M) Expected loss on the sale (5M) Tax rate = 50%, Fiscal year end =12/31

Discontinued Operation-Solution X Company X Company Income Statement, 12/31/96 Income Statement, 12/31/96 Income from continuing operation.....$xxx Discontinued operation: Income from operation (net of tax) M (A) Loss on disposal (net of tax) (1.5M) (B) Subtotal (0.5M) Subtotal (0.5M) Net income $xxx

Extraordinary Items ä Definition and Criteria ä Material; unusual; non-recurring (infrequent) ä Qualifying Examples ä Casualty gain or loss; foreign expropriation; ä Gains or losses from extinguishment of debt ä Nonqualifying Examples ä Write-down of assets; strike; abandonment of property; foreign exchange gains or losses

Cumulative Effects from Changes in Accounting Principle ä Definition and Criteria: ä Change from one generally accepted principle or method to another ä Qualifying examples ä FIFO to Average; DDB to S-L ä Nonqualifying examples Changes in estimates; from non-GAAP to GAAP

Changes in Accounting Principles--Reporting ä General rules: ä The cumulative effect of the change on prior years’ income is separately reported on I/S ä This year’s effect is reflected in regular operating income ä Exceptions: ä Some accounting changes (LIFO to other methods ; L-T contracts; FASB mandated) require retroactively restate prior years’ F/S

Changes in Accounting Estimates ä Definition and Criteria: ä Normal, recurring corrections and adjustments ä Examples: ä Changes in life and salvage value of equipment ä Changes in warranty liability; bad debt estimate ä Reporting: ä Require no retroactive corrections; use the new estimates to determine this year and the following years’ income

Unusual Gains or Losses ä Criteria: ä Material; unusual or infrequent but not both; do not qualify for extraordinary treatment ä Examples ä Loss from sale of a product line; strike; earthquake loss in California ä Reporting: ä included in other gains or losses section of I/S

Prior Period Adjustments (PPA) ä Qualifying Transactions: ä Correction of errors in F/S of prior periods ä Tax benefits from pre-acquisition NOL carryover ä Certain changes in accounting principles ä Reporting ä Adjustments to beginning balance of R/E on the Statement of R/E; requires adjusting entries involving R/E account

Inter- and Intra-period Tax Allocation ä Let taxes follow income (matching principle) ä Inter-period tax allocation matches income tax expenses to associated income in different periods ä Intra-period tax allocation matches income tax expenses to associated income items within the same period

Earnings Per Share (EPS) ä EPS is the most important single figure in the financial market EPS= Net Income - Preferred Dividends EPS= Net Income - Preferred Dividends W.A. Common Shares Outstanding W.A. Common Shares Outstanding ä EPS must be provided for each of the special items on the income statement