Powerpoint slides by: Copyright © 2003 McGraw-Hill Ryerson Limited, Canada Michael L. Hockenstein  Commerce Department Vanier College Intermediate Accounting Thomas H. Beechy Schulich School of Business, York University Joan E. D. Conrod Faculty of Management Dalhousie University

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-2 The Income Statement and the Retained Earnings Statement Chapter 3

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-3 Introduction  The income statement is the primary source of information for a company’s current profit performance  Financial statement readers use this and other information to: estimate the amount, timing, and uncertainty of the firm’s future income and cash flow evaluate performance provide feedback

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-4 Nature of Income  Change in Retained Earnings  Economic Income versus Accounting Income  Inclusiveness of the Income Statement

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-5 Change in Retained Earnings

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-6 Economic Income vs. Accounting Income  Economic Income: an increase in the wealth of a corporation; a measure of income based on events rather than transactions  Events approach : a method of assessing financial performance and position based on economic events rather than completed transactions

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-7 Economic Income vs. Accounting Income (cont.)  Accounting income: an increase in the reported wealth of a corporation based on actual transactions completed; a measure of income based on the accounting model  Transactions approach : a method of assessing financial performance and position based on completed transactions rather than events

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-8 Inclusiveness of the Income Statement  Which items affecting shareholders’ equity should be included in the computation of net income & reported in the income statement?  Two extreme approaches offered: Current operating performance: includes only items that are part of the ordinary recurring operations of the firm; gains and losses in prior periods, or unusual or non-recurring activities are recorded as direct adjustments to retained earnings.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-9 Inclusiveness of the Income Statement (cont.)  All-inclusive approach: includes all transactions affecting the net increase or decrease in equity during the period, except contributions by, or distributions to, the owners

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-10 Inclusiveness of the Income Statement (cont.)  Current practice in Canada reflects an approach closer to the all-inclusive approach  Virtually all items affecting equity (minus investment by or distributions to owners) are included in net income  The AcSB has largely eliminated the possibility of charging or crediting items directly to retained earnings, except for corrections of errors and for restatements due to changes in accounting policies

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-11 General Presentation Format  Accounting standards require three specific subtotals on its income statement, when applicable: income before extraordinary items & discontinued operations: income from continuing operations income before discontinued operations: after adding and subtracting extraordinary gains and losses, if any net income: after adding and subtracting gains and losses from discontinued operations

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-12 General Presentation Format (cont.)  CICA Handbook requires a few specific items be disclosed (CICA ) revenues recognized investment income amortization expense research and development expense interest expense income tax expense earnings per share

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-13 Single Step Format  Single-step format uses only two broad classifications for presenting income from continuing operations: a section showing revenues and gains a section showing expenses and losses  Income from continuing operations is computed in one step, without intermediate subtotals

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-14 Multiple-Step Fully Classified  The various categories of revenue and expense that appear on a fully classified income statement are: operating revenues cost of sales operating expenses operating income from continuing operations other income and expense income tax discontinued operations

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-15 Other Format Choices Title Fiscal Year End Reporting Period’s Length and Composition Reporting Currency Selection of GAAP Rounding Language Comparative Data Detail

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-16 Income as a Predictive Tool  Earnings trends are important analytical tools used by investment analysts and investors in forecasting a company's future earnings  Forecasts of future earnings are one factor often used in making investment decisions  Past trends and performance do not guarantee continuation of such trends and performance in the future, but they are often useful predictors

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-17 Special Aspects of the Income Statement  Intraperiod income tax allocation  Restructuring charges  Discontinued operations  Extraordinary items  Unusual items

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-18 Intraperiod Tax Allocation  Item shown net of related tax: the tax consequences of the item have been determined and the reported amount is shown after these tax effects have been adjusted for  Intraperiod tax allocation: intra means that the allocation is within the period and within the income statement and retained earnings statement  Interperiod tax allocation: the allocation of tax expense to different reporting periods

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-19 Restructuring Charges  The Emerging Issues Committee prescribes that the estimated costs and losses be charged to operations in the year the restructuring decision is made  This policy is consistent with the policy applied to discontinued operations

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-20 Discontinued Operations  Discontinued operations are treated similar to restructuring charges except that the gain/loss associated with the discontinued operations are segregated on the income statement a manufacturer eliminates a significant and distinguishable product line a food distributor that normally sells its products directly to restaurants sells its wholesale division that sold products to its retail outlets

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-21 Discontinued Operations (cont.)  Specifically, two components of income resulting from discontinued operations must be disclosed separately: results of operations for the discontinued segment before the disposal decision, net of tax gain or loss (net of tax) from disposal of a segment of a business, including the income or loss from operating the business during any phase out period

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-22 Discontinued Operations (cont.)  Full disclosure of a discontinued operation includes the following: identification and description of the business segment discontinued the measurement date and the actual or projected disposal date the actual or expected manner of disposition a description of the assets, by major classification, of the discontinued segment revenue attributable to the discontinued segment for the reporting period

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-23 Extraordinary Items  Section 3480, CICA Handbook–Transactions or events that have all of the following characteristics: are not expected to occur frequently over several years do not typify the normal business activities of the entity do not depend primarily on decisions or determinations by management or owners

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-24 Extraordinary Items (cont.)  Section 3480– Events that are not extraordinary items: losses and provisions for losses with respect to bad debts and inventories gains and losses from fluctuations in foreign exchange rates adjustments with respect to contract prices gains and losses from write-down or sale of property, plant, equipment, or other investments income tax reductions on utilization of prior period losses or reversal of previously recorded tax benefits

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-25 Unusual Items The CICA Handbook recommends that companies report separately “revenues, expenses, gains or losses resulting from items that do not have all the characteristics of extraordinary items but result from transactions or events that are not expected to occur frequently over several years, or do not typify normal business activities of the entity” [CICA (1)] Note: Such items should not be shown net of tax.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-26 Earnings Per Share  Public companies are required to report earnings per share  Earnings per share (EPS) is a summary figure that is often quoted by analysts and investors as the primary (and sometimes only) indication of a company’s earnings record  Public companies are required to report earnings per share for both (1) income before discontinued operations and extraordinary items, and (2) net income

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-27 Earnings Per Share (cont.).  Basic earnings per share: computed by dividing reported income available to the holders of common shares by the weighted average number of common shares outstanding during the year  Fully diluted earnings per share: shows how earnings per share would change in the event that all common shares promised under the terms of existing option agreements, conversion privileges on bonds or preferred shares, etc., were actually issued

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-28 Retained Earnings Statement  The purpose of the retained earnings statement is: to report all changes in retained earnings during the accounting period to reconcile the beginning and ending balances of retained earnings to provide a connecting link between the income statement and the balance sheet

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-29 Retained Earnings Statement (cont.)  The major components of a statement of retained earnings are: 1. Net income or loss for the period 2. Dividends 3. Error corrections 4. Cumulative effect of retroactive changes in accounting policy 5. Other changes, e.g., capital transactions, appropriations, and restrictions

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-30 Retained Earnings Statement (cont.)  Error corrections  Retroactive effect of a change in accounting policy  Capital transactions  Other charges  Appropriations of and restrictions on retained earnings  Prior period adjustments

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-31 Error Corrections  Sometimes involves restating the financial statements of prior years, and thus changing prior income that is summarized in retained earnings  Proper disclosure of these changes is accomplished by making an adjustment to opening retained earnings for the cumulative impact of the change to prior income, net of tax

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-32 Error Corrections  Opening retained earnings as restated are presented  Then, the comparative financial statements are adjusted to give effect to the error correction  A description of the error and its effect on the financial statements must be included in the disclosure notes

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-33 Retroactive Effect of a Change in Accounting Policy  The retroactive effect of a change in accounting policy is also reflected on the retained earnings statement  When an accounting policy is changed, the comparability of the financial statements is compromised unless all comparative numbers, including prior years’ net incomes, are restated using the newly adopted principle  This change in prior years’ income also changes opening retained earnings as previously reported

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-34 Capital Transactions  Most capital transactions are share transactions  Gains and losses caused by these transactions are not shown on the income statement because they are not arm’s length transactions  Gains normally create contributed capital  separate shareholders’ equity accounts  and losses reduce retained earnings

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-35 Other Charges  Other charges to retained earnings result from: share issue expenses incurred on the issuance of new shares taxes resulting from a change in control or triggered by dividend payments to shareholders adjustments to retained earnings caused by a reorganization

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-36 Restrictions on Retained Earnings  Restrictions result from legal requirements, such as a statutory requirement that retained earnings be restricted for dividend purposes by the cost of any treasury stock held

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-37 Appropriations of Retained Earnings  Appropriations of retained earnings result from formal decisions by the corporation to set aside, or appropriate, a specific amount of retained earnings (temporarily or permanently)  The effect of an appropriation is to remove the specified amount of retained earnings from dividend availability

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada   3-38 Prior Period Adjustments  In line with the all-inclusive concept of income, the AcSB decided that prior period adjustments were, in fact, related to normal operations and should be recorded on the face of the income statement Note: The category no longer exists