The Income Statement and the Statement of Cash Flows C hapter 5 COPYRIGHT © 2010 South-Western/Cengage Learning Intermediate Accounting 11th edition Nikolai Bazley Jones An electronic presentation By Norman Sunderman and Kenneth Buchanan Angelo State University

2 Capital Maintenance Concept Under this concept, corporate income for a period of time is the amount that may be paid to stockholders during that period and still enable the corporation to be as well off at the end of the period as it was at the beginning. Concepts of Income

3 Transactional Approach Under this concept, a company records its net assets at their historical cost, and it does not record changes in the assets and liabilities unless a transaction, event, or circumstance has occurred that provides reliable evidence of a change in value. Concepts of Income

4 The transactional approach to income measurement is used in accounting today. Concepts of Income

5 Transactional Approach A corporation’s net income for an accounting period currently is measured as follows: Net income = Revenues – Expenses + Gains – Losses Concepts of Income

6 Purposes of the Income Statement 1.To help evaluate management's past performance. 2.To help predict the company’s future income and cash flows. 3.To help assess the company’s “creditworthiness.” 4.To help in comparisons with other companies.

7 Revenues are inflows of (increases in) assets of a company or settlement of its liabilities during a period… Revenues

8 …from delivering or producing goods, rendering services, or other activities that are the company’s ongoing major or central operations. Revenues

9 Recognition is the process of formally recording and reporting an item in a company’s financial statements when they are earned. Revenue Recognition

10 A company usually recognizes revenue at the time goods are sold or services are rendered. Revenue Recognition

11 Expenses are outflows of (decreases in) assets of a company or incurrences of liabilities during a period from delivering or producing goods,… …rendering services, or carrying out other activities that are the company’s ongoing major or central operations. Expenses

12 Expense Recognition 1.Association of Cause and Effect (cost of products sold and sales commissions) 2.Systematic and Rational Allocation (depreciation) 3.Immediate Recognition (period costs) The FASB has identified three expense recognition principles to properly match expenses against revenues:

13 Cost: Asset or Expense Transaction Cost ContinuedContinued If a cost results in an economic resource providing future benefits, record it as an... AssetAsset

14 If a cost is a result of providing goods or services in a time period, record it as an... ExpenseExpense Transaction Cost Cost: Asset or Expense

15 If the benefits have been used up, the asset is charged off to an expense. Cost: Asset or Expense

16 Gains and Losses Gains and losses relate to peripheral or incidental activities or to the effects of other events and circumstances. They are reported “net” (not net of tax) in contrast to revenues and expenses, which are reported “gross.”

17 1.Income from continuing operations a.Sales revenue (net) b.Cost of goods sold c.Gross profit d.Operating expenses e.Income from operations f.Other items g.Income from continuing operations before tax h.Income tax expense related to continued operations i.Income from continuing operations Income Statement Content

18 2.Results from discontinued operations a.Income (loss) from operations of discontinued components (net of income taxes) b.Gain (loss) from disposals of discontinued components (net of income taxes. a.Income (loss) from operations of discontinued components (net of income taxes) b.Gain (loss) from disposals of discontinued components (net of income taxes. Income Statement Content

19 3.Extraordinary items (net of income taxes) 4.Net income 5.Earnings per share Income Statement Content That’s it!

20 Operating Expenses Operating expenses are those primary recurring costs (other than cost of goods sold) incurred to generate sales revenue.

21 Other Items Other items includes those significant recurring items of revenue and expense that are not directly related to the primary operations of the company.

22 Interperiod Tax Allocation Interperiod tax allocation involves allocating a corporation’s income tax obligation as an expense to various accounting periods because of temporary (timing) differences between its taxable income and pretax financial income.

23 Intraperiod tax allocation involves allocating a corporation’s total income tax expense for a period to the various components of its net income, retained earnings, and other comprehensive income (if any). Intraperiod Tax Allocation

24 1.Income from continuing operations 2.Income (loss) from the operations of a discontinued component 3.Gain (loss) from the disposal of a discontinued component 4.Extraordinary items 5.Any items of other comprehensive income 6.Any prior adjustments Income tax expense is matched against: Intraperiod Tax Allocation

25 Discontinued Operations A company may decide to “discontinue” some of its operations and sell a component of these operations. What is a component?

26 Discontinued Operations A component of a company involves operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the company. A component may be a subsidiary, an operating segment, or an asset group.

27 Note that discontinued operations are reported on the income statement after the continuing operations, but before extraordinary items. Income Statement: Results from Discontinued Operations

28 Sale of a component. The company decides to exit the beauty care business and sells the product group. This is a sale of a component. Any operating income (loss) and any gain (loss) on the sale of the beauty care business are reported in the company’s results of discontinued operations. What Is a Component? Not a sale of a component. The company decides to stay in the beauty care business but to sell the brands that are generating operating losses. This is not a sale of a component because the brands are only part of a product group. Any operating income (loss) and any gain (loss) on the sale of the brands are reported in the company’s income from continuing operations.

29 Sale of a component. The company sells the company-owned restaurants in that region to another company. This is a sale of a component. Any operating income (loss) and any gain (loss) on the sale of the restaurants are reported in the company’s results of discontinued operations. What Is a Component? Not a sale of a component. The company decides to sell the company-owned restaurants in that region to an existing franchisee. This is not a sale of a component because the company will receive franchise fees and have significant continuing involvement in the operations of the restaurants. Any operating income (loss) and any gain (loss) on the sale of the company-owned restaurants are reported in its income from continuing operations.

30 Sale of a component. The company decides to exit the bicycle business and sells the division. This is a sale of a component. Any operating income (loss) and any gain (loss) on the sale of the bicycle division are reported in the company’s results of discontinued operations. What Is a Component? Not a sale of a component. The company decides to remain in the bicycle business but outsources the manufacturing operations and sells the related manufacturing facility. This is not a sale of a component because the manufacturing facility is only part of the bicycle division. Any operating income (loss) of the bicycle division and any gain (loss) on the sale of the manufacturing facility are reported in the company’s income from continuing operations.

31 1.Management has committed to a plan to sell the component 2.The component is available for immediate sale in its present condition 3.Management has begun an active program to locate a buyer Held for Sale Sale in a Later Accounting Period GAAP requires that all of the following criteria be met to qualify for “held for sale”:

32 4.The sale is probable within one year 5.The component is being offered for sale at a price that is reasonable in relation to component’s fair market value 6.It is unlikely that management will make significant changes to the plan Held for Sale Sale in a Later Accounting Period GAAP requires that all of the following criteria be met to qualify for “held for sale”:

33 When a company classifies a component as held for sale, it records and reports the component at the lower of (1) its book value (book value of assets minus book value of liabilities) or (2) its fair value (the amount at which the assets and liabilities as a whole could be sold in a current single transaction) less any cost to sell. Sale in a Later Accounting Period

34 Disclosures Required by GAAP  A description of the facts and circumstances leading up to the sale, and, if held for sale, the expected manner and timing of the sale  The revenues and pretax income (loss) of the component included in its operating income (loss) reported in the results from discontinued operations section of the company’s income statement ContinuedContinued Disclosures

35  If not separately reported on its income statement, the gain (loss) on the sale and the caption on the income statement that includes the gain (loss)  If not separately reported on its balance sheet, the book value of the major classes of assets and liabilities Disclosures Required by GAAP Disclosures

36 Extraordinary Items Unusual nature— the underlying event or transaction possesses a high degree of abnormality and is of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the company. An extraordinary item is an event or transaction that is both unusual in nature and infrequent in occurrence.

37 Extraordinary Items Infrequency of occurrence— the underlying event or transaction is of a type that is not reasonably expected to recur in the foreseeable future. An extraordinary item is an event or transaction that is both unusual in nature and infrequent in occurrence.

38 Extraordinary Items An extraordinary item is an event or transaction that is both unusual in nature and infrequent in occurrence. Unusual nature— the unusual nature criterion depends upon the environment in which a company operates. An event may be unusual in nature for one company but not another.

39 One other item is required to be reported as an extraordinary item. As prescribed by GAAP, when a company purchases another company and pays less than the fair value of the net assets of the other company, it reports the difference as an extraordinary gain. Extraordinary Items

40 1.The write-down or write-off of receivables, inventories, equipment leased to others, or intangible assets 2.Gains or losses from exchanges or translation of foreign currencies 3.Gains or losses from the disposal of business components Nonextraordinary Items Events identified as not qualifying as extraordinary include: ContinuedContinued

41 4.Other gains or losses from the sale or abandonment of property, plant, or equipment 5.The effects of a strike 6.The adjustment of accruals on long-term contracts 7.The effects of a terrorist attack Nonextraordinary Items Events identified as not qualifying as extraordinary include:

42 Earnings per share information must be reported on a company’s income statement, and this disclosure usually is shown directly below the net income. Earnings per share refers only to common stock. In its simplest form, earnings per share is computed by dividing the net income by the number of common shares outstanding throughout the entire year. Earnings Per Share

43 Change in Accounting Estimate When a company changes an accounting estimate, it accounts for the change in the current year, and in future years if the change affects both. Because companies present financial information on a periodic basis, accounting estimates are necessary, and changes in these estimates frequently occur.

44 Retained earnings is the link between a corporation’s income statement and its balance sheet. Statement of Retained Earnings

45 Comprehensive Income Recall that the FASB now requires companies to report their comprehensive income (or loss) for the accounting period. A company’s comprehensive income consists of two parts: net income and other comprehensive net income. ContinuedContinued

46 1.Any unrealized increase (gain) or decrease (loss) in the fair value of its investments in available-for-sale securities 2.Certain pension plan gains, losses, and prior service cost adjustments 3.Certain gains and losses on “derivative” financial instruments 4.Any transaction adjustment from converting the financial statements of its foreign operations into U. S. dollars Comprehensive Income Currently, there are four items of a company’s other comprehensive income:

47  On the face of its income statement  In a separate statement of comprehensive income  In its statement of changes in stockholders’ equity The FASB allows a company to report its comprehensive income (or loss) under three alternatives: The company must display the statement containing the comprehensive income as a major financial statement in its annual report. Comprehensive Income

48 In reporting its comprehensive income, a company must add its other comprehensive income to its net income. The other comprehensive income items may be reported at their gross amounts or net of tax. If each item is reported at its gross amount, then the total pretax amount of other comprehensive income must be reduced by the related income tax expense. A company is not required to report earnings per share on its comprehensive income. Comprehensive Income

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