Chapter Three The Income Statement and Comprehensive Income Disclosures

Copyright © Houghton Mifflin Company.All rights reserved What Is Income? One of the most meaningful figures that a firm reports Significant measure of past performance Indicates potential for future prospects Relates to whether a firm is better off at the end of a period than it was at the beginning (apart from capital contributions/withdrawals)

Copyright © Houghton Mifflin Company.All rights reserved Determining Net Income Economic Approach: Change in net wealth due to a change in the current value of an asset Accounting Approach: Net income derived from business transactions

Copyright © Houghton Mifflin Company.All rights reserved Critical Thinking Discussion: Consider how you measure income in your personal finances. Do you measure your income in relation to specific transactions? If you measure your income in relation to receipt of a paycheck or interest from your bank, then you use a transaction-based, or accounting approach.

Copyright © Houghton Mifflin Company.All rights reserved Accrual Accounting Foundation for determining net income under GAAP Record transactions and events in the period in which they occur rather than in the period when cash or payment is received or paid Based on matching principle and revenue recognition principle

Copyright © Houghton Mifflin Company.All rights reserved The Income Statement Provides information about the amount of net income earned over a stated period of time, detailing the revenues earned and the expenses incurred + Revenues - Expenses + Gains - Losses Net Income

Copyright © Houghton Mifflin Company.All rights reserved Income Statement: Single-Step Format Revenues and gains in one category Expenses and losses in another category No distinction made between operating activities and nonoperating activities Many variations on the single-step format are used in practice

Copyright © Houghton Mifflin Company.All rights reserved Multiple-Step Income Statement Operating Section Net sales Cost of goods sold Gross profit Selling/administrative expenses Other operating income and expenses Nonoperating Section Net interest revenue or expense Any other nonoperating revenues and expenses

Copyright © Houghton Mifflin Company.All rights reserved Items That Affect Net Income Recurring Items: Transactions related to ongoing operating activities Sales Cost of sales Administrative expenses Selling expense Gains/losses on operating assets Nonrecurring Items: Transactions that are unusual, infrequent, or unrelated to normal operations Discontinued operations Extraordinary items Cumulative effect of change in accounting principle

Copyright © Houghton Mifflin Company.All rights reserved Discontinued Operations Presented separately from income from continuing operations

Copyright © Houghton Mifflin Company.All rights reserved What Constitutes a Discontinued Operation? Segment of a business–a subsidiary, division, or department whose assets are clearly distinguished from the firm’s other assets and operations, OR Component of an entity–operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity

Copyright © Houghton Mifflin Company.All rights reserved Component of an Entity Being Held for Sale (Or Sold) Qualifies as a discontinued operation if: Operations and cash flows of component will be (or have been) eliminated from the ongoing operations of the firm Entity will not have significant continuing involvement in the operations of the component If component qualifies as a discontinued operation: Report both revenues or losses from operations of the component plus any gain or loss on its disposal separately from income from continuing operations, net of tax

Copyright © Houghton Mifflin Company.All rights reserved Extraordinary Items Unusual High degree of abnormality Unrelated to ordinary activities of the firm Infrequent Not expected to recur in the foreseeable future given the nature of the firm’s environment Material Large enough to make a difference in investors’ decisions

Copyright © Houghton Mifflin Company.All rights reserved Accounting Changes A switch or change in accounting principle that is either chosen by management or mandated by the FASB or SEC A modification or change in an accounting estimate The correction of an error, which, although not technically an accounting change, is treated in a similar manner

Copyright © Houghton Mifflin Company.All rights reserved Types of Accounting Changes

Copyright © Houghton Mifflin Company.All rights reserved Change in Accounting Principle Cumulative effect of change on prior years’ earnings reported net of tax after income from continuing operations Effect of change on current year’s earnings reported in continuing operations Carrying value of the asset or liability associated with the change is recalculated and adjusted

Copyright © Houghton Mifflin Company.All rights reserved Change in Accounting Estimate If changing the estimated life of an asset Calculate new depreciation schedule Record new depreciation expense incorporating the change in current period If revising the amount of uncollectible accounts Make change in current period as an adjustment to bad debt expense in ordinary operating income

Copyright © Houghton Mifflin Company.All rights reserved Error Correction Illustration: Assume Angel Co. neglected to record equipment depreciation of $15,000 per year for the past two years. Assume the company’s tax rate is 35 percent. How is this error corrected? Retained Earnings [$30,000 x (1 -.35)] 19,500 Income Tax Refund Receivable ($30,000 x.35) 10,500 Accumulated Depreciation 30,000

Copyright © Houghton Mifflin Company.All rights reserved Intraperiod Tax Allocation The practice of relating income tax expense to the specific item or event that cause the tax On the income statement, report income tax resulting from continuing operations as a separate line. Report nonrecurring items (discontinued operations, extraordinary items, and cumulative effect of change in accounting principle) net of their tax effects

Copyright © Houghton Mifflin Company.All rights reserved Earnings Per Share The amount of earnings associated with each share of common stock EPS = Net Income-Preferred Stock Dividends Weighted-Average Number of Common Shares Outstanding

Copyright © Houghton Mifflin Company.All rights reserved Reporting Earnings Per Share Statement of Financial Accounting Standards No. 128 requires that EPS be reported for: Income from continuing operations Discontinued operations Extraordinary items Cumulative effects of a change in accounting principle Net income

Copyright © Houghton Mifflin Company.All rights reserved Comprehensive Income Income resulting from transactions that are primarily derived from events external to the firm: Unrealized gains/loss on marketable securities held in the available-for-sale portfolio (Ch. 11) Unrealized gains/losses resulting from foreign currency translations Amounts that result from recording the minimum pension obligation (Ch. 15)

Copyright © Houghton Mifflin Company.All rights reserved Reporting Comprehensive Income Components of comprehensive income may be reported in one of the following ways: One statement—net income and comprehensive income are added together to obtain total comprehensive income Two statements—net income reported on one statement and comprehensive income reported on another statement Report comprehensive income as part of the statement of changes in stockholders’ equity

Copyright © Houghton Mifflin Company.All rights reserved Analyzing the Income Statement Commonly used measurements: Gross Profit Gross Profit Percentage Operating Margin Operating Margin Percentage Profit Margin on Sales

Copyright © Houghton Mifflin Company.All rights reserved Gross Profit Amount earned before operating expenses Gross Profit = Net Sales – Cost of Sales Dell Computer Corporation Excerpt from Consolidated Statements of Income Fiscal Year Ended January 1, 2003 (in millions) Net revenue$35,404 Cost of revenue 29,055 Gross margin 6,349

Copyright © Houghton Mifflin Company.All rights reserved Gross Profit Percentage Amount (expressed as percentage) of gross profit earned on each dollar of sales Gross Profit Percentage = Gross Profit  Net Sales Dell Computer Corporation Excerpt from Consolidated Statements of Income Fiscal Year Ended January 1, 2003 (in millions) Net revenue$35,404 Cost of revenue 29,055 Gross margin 6,349 $6,349 million  $35,404 million= percent

Copyright © Houghton Mifflin Company.All rights reserved Operating Margin Amount the firm generates after operating expenses and cost of sales (also called operating income) Net Sales – (Cost of Sales + Operating Expenses) Dell Computer Corporation Excerpt from Consolidated Statements of Income Fiscal Year Ended January 1, 2003 (in millions) Net revenue$35,404 Cost of revenue 29,055 Gross margin 6,349 Total operating expenses 3,505 Operating income 2,844

Copyright © Houghton Mifflin Company.All rights reserved Operating Margin Percentage Indicates how much operating margin is generated on each dollar of sales Operating Margin  Net Sales Dell Computer Corporation Consolidated Statements of Income Fiscal Year Ended January 1, 2003 (in millions) Net revenue$35,404 Cost of revenue 29,055 Gross margin 6,349 Total operating expenses 3,505 Operating income 2,844 $2,844 million  $35,404 million = 8.03 percent

Copyright © Houghton Mifflin Company.All rights reserved Profit Margin on Sales Amount of net income earned on each dollar of sales Net Income  Net Sales Dell Computer Corporation Year Ended January 31, 2003 $2,122 million  $35,404 million = 5.99 percent

Copyright © Houghton Mifflin Company.All rights reserved Check Your Understanding QWhat is accrual accounting? AAccrual accounting dictates that transactions and other events and circumstances are recorded in the period in which they occur rather than in the period in which cash or some other form of payment is received or paid.

Copyright © Houghton Mifflin Company.All rights reserved Check Your Understanding QIf your company prefers to separate operating from nonoperating activities on its income statement, which format would be used? AThe multiple-step format divides operating from nonoperating items.

Copyright © Houghton Mifflin Company.All rights reserved Check Your Understanding QWhat are the three characteristics that define an extraordinary item? AExtraordinary items are unusual, infrequent, and material.

Copyright © Houghton Mifflin Company.All rights reserved Check Your Understanding QHow do you determine whether a component of an entity that is being held for sale can be considered a discontinued operation? AThe component can be considered a discontinued operation: (1) if the operations and cash flows of the component will be eliminated from the ongoing operations of the entity, and (2) the entity will not have any significant continuing involvement in the operations of the component.

Copyright © Houghton Mifflin Company.All rights reserved Check Your Understanding QIf a change has been made to an accounting estimate, how is this change reflected on the income statement? AThe cumulative effect of the change on prior years’ earnings is reported net of tax after income from continuing operations. The effect of the change on the current year’s earnings are reported in continuing operations.

Copyright © Houghton Mifflin Company.All rights reserved Check Your Understanding QWhy is EPS an important measurement to investors and analysts? AEPS indicates, on a per share basis, the income of the current period for both the recurring and the nonrecurring items that are associated with the common shareholders’ ownership interest.

Copyright © Houghton Mifflin Company.All rights reserved Check Your Understanding QList items that would be considered nonrecurring on the income statement. ADiscontinued operations, extraordinary itmes, and the cumulative effect of a change in accounting principle would be considered nonrecurring items.