Chapter 4 Schedule 9/26 Income Measurement and Income Statement Form pps. 153—166 10/01 Components of the Income Statement, Comprehensive Income & Stockholders Equity pps. 167--187 10/03 no class 10/08 completion of chapter 4 Required problems: 40, 41, 48, 51 Exam 4 opens 10/08, closes 10/09

Learning Objectives—chapter 4 Define the concept of income. Explain why an income measure is important. Explain how income is measured, including the revenue recognition and expense matching concepts. Understand the format of an income statement.

Learning Objectives (cont.) Describe the specific components of an income statement. Compute comprehensive income and prepare a statement of stockholders’ equity. Construct simple forecasts of income for future periods.

INCOME—FASB CONCEPTUAL FRAMEWORK “information about earnings and its components measured by accrual accounting generally provides a better indication of enterprise performance than information about current cash receipts and payments.”

What is Income? Income is a Return over and above the investment Income is the amount an entity could return to investors and still leave the entity as “well-off” at the end of the period as it was at the beginning

Income Determination Financial Capital Maintenance Concept states: Net assets (ending)- Net assets (beginning) = Income IF: No investments by owners or distributions were made in the period. Thus, the change in net assets could be equal to income for the period.

Financial Capital Maintenance Kreidler, Inc. had the following assets and liabilities at the beginning and at the end of a period. Beginning of Period End of Period Total assets $510,000 $560,000 Total liabilities 430,000 390,000 Net assets (owners’ equity) $ 80,000 $170,000 Income is $90,000

Financial Capital Maintenance If the owners invested $40,000 in the business and received dividends of $15,000, what would be the income? Net assets, end of period $170,000 Net assets, beginning of period 80,000 Increase in net assets $ 90,000 Deduct investment by owners (40,000) Add dividends to owners 15,000 Income $ 65,000

Why is Income measurement important? Inherently important as a major component of business and evaluation of activities Helps assist in allocating resources to the most efficient and effective use Used by creditors, investors, govt.

How is Income measured? The transaction approach yields the same net income number as financial capital maintenance and provides means of measuring cash flows as well. Also known as the matching method.

How is Income measured? Transaction approach focuses on business events that affect financial statement elements: revenues, expenses, gains, losses Measures the net effect over time

Problems with Income measurement At what point should we recognize a revenue or gain When should an expense or loss be matched

Revenue and Gain Recognition Revenue is recognized when goods or services have been provided and the customer commits to payment. Revenues & gains recognized when: They are realized* or realizable*, and They have been earned through substantial completion of the activities involved in the earnings process. Realized means payment has been received Relizable means we have received an asset that is convertible to cash

Earlier Recognition Situations where revenue can be recognized earlier: If a product will sell at an established price which is practically ensured without significant selling effort. If a product or service is contracted for in advance, revenue may be recognized as production occurs (percentage-of-completion or proportional performance methods of revenue recognition.

Later Recognition If payment for products or services is considered doubtful, revenues and gains may be recognized as the cash is received. Installment Sales method Cost Recovery method Point-of-sale method will generally be followed for our problems unless othewise indicated

Expenses and Loss Recognition Three categories for expense recognition: Direct Matching Systematic and rational allocation Immediate recognition

Expenses and Loss Recognition Direct Matching- relating expenses to specific revenues. Systematic and Rational Allocation- costs of assets that benefit more than one period are spread across periods in a systematic and rational way. (depreciation) Immediate Recognition- expenses that do not relate to specific revenues, but are incurred to indirectly generate revenue or when future benefits are highly uncertain. (admin expenses)

Let’s Practice 4-1, 3, 4, 5 Ex 22, 23, 24, 25

Form of the Income Statement Traditionally, income from continuing operations is presented: In a single step form- all revenues and gains are first on the statement. Multiple step form- divided into separate sections and various subtotals are reported that reflect different levels of profitability.

Form of the Income Statement Revenue $xxx Costs and expenses: Costs of sales xxx Selling and administrative xxx Interest expense xxx Other income/expense, net xxx Restructuring charge xxx Total costs and expenses xxx Income before income taxes xx Income taxes xx Net income $ xx Single-Step Income Statement

Form of the Income Statement Revenue $xxx Costs of goods sold: Beginning inventory xxx Net purchases xxx Cost of goods available for sale xxx Less ending inventory xxx xxx Gross profit on sales xxx Operating expenses: Selling expenses xxx General expenses xxx xxx Other income xxx Multiple-Step Income Statement

Form of the Income Statement Other income (from previous page) $xxx Other revenue and gains xxx Other expenses and losses (xxx ) Income from continuing operations before income taxes xxx Income taxes on continuing operations (xxx ) Net income from Continuing Operations xxx

Form of the Income Statement Continued: Discontinued operations: Loss from operations of discontinued business segment (net of tax) $xxx Loss on disposal of segment (net of tax) xxx (xxx ) Extraordinary gain (net of tax) xxx Net income $xxx Cumulative Effect of a Change in Accounting Principle (net of tax) xxx ========= *Comprehensive items may be shown as a note to arrive at Comprehensive Net Income

Form of the Income Statement Comparative financial statements present several years’ financial statements side by side. This enables users to analyze performance over multiple periods and identify significant trends. Consolidated financial statements combine the financial results of the “parent company” with other companies that it owns, called subsidiaries.

Income from Continuing Operations Determining Subtotals: Income from Continuing Operations Before Taxes = Operating income + Other revenues and gain – Other expenses and losses Income from continuing operations = Income from continuing operations before income taxes – Income taxes on continuing operations

Components of the Income Statement Income from Continuing Operations: Revenue Cost of goods sold Operating expenses Other revenues and gains Other expenses and losses Income taxes on continuing operations

Income from Continuing Operations Determining Subtotals: Gross profit = Revenue – Cost of goods sold Operating income = Gross profit – Operating expenses

Components of the Income Statement Revenue Revenue reports the total sales to customers for the period less any sales returns and allowances or discounts. Does not include taxes or shipping charges.

Components of the Income Statement Cost of Goods Sold Beginning inventory + Net purchases + Freight-in + Other inventory acquisition costs = Cost of goods available for sale – Ending inventory = Cost of goods sold Cost of goods sold is a significant item on merchandising and manufacturing companies’ income statement.

Components of the Income Statement Gross Profit Net sales – Cost of goods sold = Gross profit Why is Gross Profit important? ---what is it used for? Gross profit ÷ Net sales = Gross profit percentage

Components of the Income Statement Operating Expenses Operating expenses may be reported in two parts: Selling expenses List some examples General and Administrative expenses

Components of the Income Statement Operating Income Operating income measures the performance of the fundamental business operations conducted by a company. Gross profit – Operating expenses = Operating income also call EBIT

Components of the Income Statement Other Revenues and Gains This section usually includes items identified with the peripheral activities of the company. List some examples: 1) Rent revenue 2) Interest revenue 3) Dividend revenue 4) Gains from the sale of assets

Components of the Income Statement Other Expenses and Losses This section parallels “Other Revenues and Gains” except the items result in deductions from operating income. List some examples 1) Interest expense Losses from the sale of assets Restructuring charges

Components of the Income Statement Income Taxes Income tax expense is calculated on income from all transactions of consequence for the year. Below the line items (transitory, irregular, and extraordinary items) are reported net of their individual tax effect. See Techtronics, p. 166

Below the Line items Discontinued operations: Loss from operations of discontinued business segment (net of tax) $xxx Loss on disposal of segment (net of tax) xxx (xxx ) Extraordinary gain (net of tax) xxx Net income $xxx Cumulative Effect of a Change in Accounting Principle (net of tax) xxx =========

Discontinued Operations Not expected to continue to impact results of future years operations To report discontinued operations: The operations and cash flows of the component must be clearly identifiable For example, discontinued operations would result if a company closed one of four operating segments which tracks its cash flows and income separately. Or may be closing of a single line or even a single store.

Discontinued Operations Management could decide to dispose of a component of a business because: The component may be unprofitable. The component may not fit into the long-range plans for the company. Management may need funds to reduce long-term debt or to expand into other areas. Management may be fearful of a corporate takeover by new investors desiring to gain control of the company.

Discontinued Operations When reporting discontinued operations on the income statement it consists of two parts: Income (loss) from operations- disclosed only if decision to discontinue operations is made after beginning of the year. Gain (loss) on disposal of operation- consisting of income (loss) during phase out and gain (loss) from disposal of segment assets.

Discontinued Operations According to FASB Statement No. 144, if on the balance sheet date assets and liabilities associated with discontinued components have not been completely disposed, they are to be listed separately in the asset and liability sections of the balance sheet. In addition to the summary income or loss number reported in the income statement, the total revenue associated with the discontinued operations should be disclosed in the financial statement notes.

To be reported as an extraordinary item the event must be BOTH: Extraordinary Items To be reported as an extraordinary item the event must be BOTH: Unusual and Infrequent.

Not Extraordinary—p. 174 Write-down or write-off of receivables, inventory, etc. Effects of a strike. Gains or losses from exchange or remeasurement of foreign currencies. Gains or losses on disposal of business segment. Gains or losses from sale or abandonment of productive assets. Adjustment of accruals on long-term contracts.

Changes in Accounting Principle To provide more useful information (not just for economic purpose.) Is usually the result of a FASB pronouncement or SEC directive

Changes in Accounting Principle Disclosure Requirements: Report current year’s income components on the new basis. Determine how the income statement would be different in past years if the new accounting method would have been used; see p. 176

Change in Estimate Estimates are always made using the best available information at the statement date Revision of estimates is normal, and part of the continuing accounting process Changes in estimates should be reflected in the current period and future periods. No retroactive adjustments are made. Disclose as supplemental note

Net Income or Loss What is it? Income or Loss from continuing operations Combined with the results of discontinued operations and extraordinary items Provides a summary of the company’s performance for a period Is often measured and compared using the ratio of return on sales: Net Income / Net Sales

Earnings Per Share Represents the amount of net income associated with a share of common stock EPS amounts are computed for income from continuing operations And EPS amounts are calculated for each irregular or extraordinary item.

Earnings Per Share Formula for Income from Continuing Operations Weighted average number of shares of common stock outstanding *less dividends paid or promised to Preferred Stock

Earnings per Share Basic EPS based on shares actually outstanding during the year Diluted EPS represents additional stock which may result from stock options or other conversion rights (resulting in a potentially larger number of shares of stock)

Widely referred to as the PE ratio Earnings Per Share Price-Earnings Ratio Market value per share Earnings per share Widely referred to as the PE ratio

Comprehensive Income Comprehensive income- the amount that reflects the change in a company’s wealth during the period. It includes items that arise from changes in market conditions unrelated to the business operations of a company. Most companies include a report of comprehensive income as part of the statement of stockholders’ equity.

Comprehensive Income The more common adjustments made in arriving at comprehensive income are: Foreign currency translation adjustments. Unrealized gains and losses on available-for-sale securities. Deferred gains and losses on derivative financial instruments.

Forecasting Future Performance Financial statements report the past, but are used to predict the future. Key to a good forecast involves identifying factors that determine a certain level of revenue or expense. Forecasting starts with a forecast for sales. Most expense forecast are driven from the sales forecast.