1. Copyright © 2015 McGraw-Hill Education. All rights reserved. Chapter 4 The Income Statement, Comprehensive Income, and the Statement of Cash Flows

2. Learning Objectives LO4-1Discuss the importance of income from continuing operations and describe its components. LO4-2Describe earnings quality and how it is impacted by management practices to manipulate earnings. SELF-STUDY LO4-3Discuss the components of operating and non-operating income and their relationship to earnings quality. LO4-4Define what constitutes discontinued operations and describe the appropriate income statement presentation for these transactions. LO4-5Define earnings per share (EPS) and explain required disclosures of EPS for certain income statement components. LO4-6Explain the difference between net income and comprehensive income and how we report components of the difference. LO4-7Describe the purpose of the statement of cash flows. (NOT COVERED!!) LO4-8Identify and describe the various classifications of cash flows presented in a statement of cash flows. (NOT COVERED!!) LO4-9Discuss the primary differences between U.S. GAAP and IFRS with respect to the income statement and statement of comprehensive income.

3. The Income Statement, Comprehensive Income, and the Statement of Cash Flows Income Statement (Statement of Operations or Statement of Earnings) Displays a company’s operating performance Comprehensive Income (other comprehensive income (OCI) or loss) Includes a few types of gains and losses that are not part of net income Statement of Cash Flows (NOT COVERED)

4. The Income Statement, Comprehensive Income, and the Statement of Cash Flows Income Statement Statement of Cash Flows Change Statements Balance Sheet Position Statement Reports changes in shareholders’ equity Reports events that caused change in cash

5. Income from Continuing Operations LO4-1 Inflows of resources resulting from providing goods or services to customers Revenues Outflows of resources incurred while generating revenue Represent the costs of providing goods and services Expenses Includes the revenues, expenses, gains, and losses pertaining to transactions that probably will continue in future periods

6. Income from Continuing Operations LO4-1 Increases or decreases in equity from peripheral or incidental transactions of an entity Examples Gains and losses from the routine sale of equipment, buildings, or other operating assets and from the sale of investment assets Gains and losses

7. LO4-1 Income from Continuing Operations Partial Income Statements (In millions, except earnings per share) Years Ended June 30 20162015

8. Single-Step Income Statement Groups all revenues and gains together and all expenses and losses together

9. Multiple-Step Income Statement Reports series of intermediate subtotals LO4-1

10. Manipulating Income and Income Smoothing Most executives prefer to report earnings that follow a smooth, regular, upward path Methods: Income shifting - “channel stuffing” Income statement classification - “big bath” accounting LO4-2 ‘bank’ their earnings by understating Use the banked profits to polish results $ Earnings 0 30% 15% Instead of:

11. Earnings Quality (SELF STUDY) Ability of reported earnings (income) to predict a company’s future earnings (Permanent Earnings) LO4-2 Transitory earnings Result from transactions that are: not likely to occur again in the foreseeable future likely to have a different impact on earnings in the future Permanent earnings Result from transactions that are likely to continue in the future There may be transitory earnings effects included in income from continuing operations

12. Partial Income Statement—GameStop Corp. LO4-3 Operating income could include some unusual items that may or may not continue in the future.

13. Operating Income and Earnings Quality LO4-3 Restructuring Costs Include costs associated with shutdown or relocation of facilities or downsizing of operations Recognized in the period the exit or disposal cost obligation actually is incurred

14. Operating Income and Earnings Quality LO4-3 Long-lived asset impairments Any long-lived asset should have its balance reduced if there has been a significant impairment of value Intangible Tangible

15. Operating Income and Earnings Quality Examples of revenue issues affecting earnings quality : A company loses a major customer that can’t be replaced Premature revenue recognition due to pressure to meet earnings expectations LO4-3

16. Non-operating Income and Earnings Quality LO4-3 Gains and losses Sale of investments Significant Current earnings Some non-operating items have generated considerable discussion with respect to earnings quality, notably gains and losses from the sale of investments.

17. Income Statements (in part)—Intel Corporation LO4-3

18. Non-operating Income: Separately Listed Items Discontinued operations must be reported separately, below income from continuing operations. The Extraordinary Item classification has now been eliminated from GAAP

19. Non-operating Income: Discontinued Operations A component of an entity is any part of the company, such as an operating segment or subsidiary, that includes operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the company. A component or group of components that has been sold or disposed of in some other way, or is considered held for sale is reported as a discontinued operation if the disposal represents a strategic shift that has, or will have, a major effect on a company’s operations and financial results.

20. Non-operating Income: Discontinued Operations Reported separately, below income from continuing operations The income tax effect of discontinued operations is included in the separate presentation rather than as part of the amount reported as income tax expense. This is referred to as intra-period tax allocation.

21. Concept Check √ The Cansela Baseball Bat Company reported income before taxes of $375,000. This amount included a $75,000 loss on discontinued operations. The amount reported as income from continuing operations, assuming a tax rate of 40%, is: a.$375,000. b.$270,000. c.$180,000. d.$225,000. [$375,000 (income before income taxes) + $75,000 (loss on discontinued operations)] × [1.0 – 0.4 (tax rate)] = $270,000

22. Accounting Changes (Not Covered) Correction of an error is another adjustment that is accounted for in the same way as certain accounting changes. LO4-4 Accounting changes fall into one of three categories change in accounting principle estimate reporting entity

23. Correction of Accounting Errors LO4-4 Caused by a transaction being recorded incorrectly or not recorded at all Errors discovered in the same year Erroneous journal entry is reversed and the appropriate entry is recorded Material errors discovered in subsequent years Require a prior period adjustment

24. Prior Period Adjustments: For, material errors discovered in subsequent years Requires that the company record a journal entry that: – adjusts any balance sheet accounts to their appropriate levels – accounts for the income effects of the error o By increasing or decreasing the beginning retained earnings balance in a statement of shareholders’ equity. o Current Year’s Income statement items (revenue or expense) are not affected!!!

25. EARNINGS PER SHARE (EPS) Earnings per share (EPS) is the amount of income expressed on a per share basis. In its simplest form, EPS is computed by dividing income available to common shareholders (net income less any preferred stock dividends) by the weighted-average number of common shares outstanding. All corporations whose common stock is publicly traded must disclose EPS. The EPS for (a) Income from Continuing Operations (b) Discontinued Operations (3) Net Income must be disclosed.

26. Earnings per Share Disclosures Ratio that indicates the amount of income earned by a company expressed on a per share basis Basic EPS Diluted EPS LO4-5 Reported on the face of the income statement Basic EPS = Net income – Preferred stock dividends Weighted-average number of common shares outstanding

27. Earnings per Share Disclosures Fetzer Corporation reported net income of $600,000 for its fiscal year ended December 31, 2016. Preferred stock dividends of $75,000 were declared during the year. Fetzer had one million shares of common stock outstanding at the beginning of the year and issued an additional one million shares on March 31, 2016. LO4-5 Basic EPS = Net income – Preferred stock dividends Weighted-average number of common shares outstanding Basic EPS = $600,000 – $75,000 1,000,000 +1,000,000( / ) 9 12 $525,000 $1,750,000 = $0.30 = Illustration:

28. EPS Disclosures—Big Lots, Inc. LO4-5

29. Problem 6 (Pages 218-219) Problem 5 (Page 218) Exercise 1 (Page 208) Exercise 2 (Page 208) Exercise 3 (Page 208) Exercise 5 (Page 209)

30. Reporting Discontinued Operations LO4-4 When the component has been sold Income or loss from operations of the component When the component is considered held for sale On disposal of the component’s assets From the beginning of the reporting period to the disposal date Gain or loss on disposal of the component’s assets From the beginning of the reporting period to the end of the reporting period An “impairment loss” if the book value of the component is more than fair value minus cost to sell. *Impairment Gain is not reported

31. Discontinued Operations: Has Been Sold —Gain on Disposal The Duluth Holding Company has several operating divisions. In October 2016, management decided to sell one of its divisions that qualifies as a separate component according to generally accepted accounting principles. The division was sold on December 18, 2016, for a net selling price of $14,000,000. On that date, the assets of the division had a book value of $12,000,000. For the period January 1 through disposal, the division reported a pretax loss from operations of $4,200,000. The company’s income tax rate is 40% on all items of income or loss. Duluth generated after-tax profits of $22,350,000 from its continuing operations. Preapre Duluth’s income statement for the year 2016, beginning with income from continuing operations, would be reported as follows: Income from continuing operations Discontinued operations: Loss from operations of discontinued component Income tax benefit: 40% x (2.2M) Loss on discontinued operations Net income $22,350,000 $(2,200,000) 880,000 (1,320,000) $21,030,000 _ [(14M - 12M) 4.2M]

32. Discontinued Operations: Held for Sale—Impairment Loss LO4-4 The Duluth Holding Company has several operating divisions. In October 2016, management decided to sell one of its divisions that qualifies as a separate component according to generally accepted accounting principles. On December 31, 2016, the end of the company’s fiscal year, the division had not yet been sold. On that date, the assets of the division had a book value of $12,000,000 and a fair value, minus anticipated cost to sell, of $9,000,000. For the year, the division reported a pre-tax loss from operations of $4,200,000. The company’s income tax rate is 40% on all items of income or loss. Duluth generated after-tax profits of $22,350,000 from its continuing operations. Duluth’s income statement for 2016, beginning with income from continuing operations, would be reported as follows: Income from continuing operations Discontinued operations: Loss from operations of discontinued component Income tax benefit: 40% x (7.2M) Loss on discontinued operations Net income $22,350,000 $(7,200,000) 2,880,000 (4,320,000) $18,030,000 _ [(14M - 12M) 4.2M]

33. Exercise 6 (Page 209) Exercise 7 (Pages 209-210) Exercise 8 (page 210) Problem 3 (Page 217 - 218)

34. Comprehensive Income Is the total change in equity for a reporting period other than from transactions with owners o Includes net income as well as other gains and losses that change shareholders’ equity but are not included in traditional net income These other gains and losses are reported as other comprehensive income (OCI) loss items OCI items: Net unrealized holdings gains and losses on investments Gains (losses) from and amendments to postretirement benefit plans Deferred gains (losses) from derivatives Gains (losses) from foreign currency translation LO4-6

35. Flexibility in Reporting LO4-6 Information in the income statement and other comprehensive income items can be presented as: Single, continuous statement of comprehensive income Two separate, but consecutive statements Income statement Statement of comprehensive income

36. LO4-6 Comprehensive Income Presented as a Separate Statement Comprehensive Income–Astro Med Inc.

37. Accumulated Other Comprehensive Income Cumulative total of OCI (or comprehensive loss) Reported as an additional component of shareholders’ equity LO4-6

38. Shareholders’ Equity—Astro-Med Inc. LO4-6 Retained Earnings Accumulated Other Comprehensive Income ($ in thousands) Balance, 1/31/13 Add: Net income Deduct: Dividends Other comprehensive income Balance, 1/31/14 $36,092 3,212 (2,103) $37,201 $173 3 $176

39. Philips Corp. purchased shares for $90 million during the year and sold them at year-end for $100 million If the shares are not sold before the end of the fiscal year but the year- end fair value is $100 million Example: Relationship between net income and other comprehensive income LO4-6 Retained Earnings Accumulated Other Comprehensive Income ($ in millions) Balance, 12/31/15 Net income Dividends Other comprehensive income Balance, 12/31/16 $600 106 (40) $666 $34 -0- $34$700 + Retained Earnings Accumulated Other Comprehensive Income ($ in millions) Balance, 12/31/15 Net income Dividends Other comprehensive income Balance, 12/31/16 $600 100 (40) $660 $34 $40$700 + (100 + 6) 100 – 90 = 10  10 – 10 (0.4) = 6 6 6

40. Exercise 4 (Page 209) Problem 7 (Page 219) Problem 8 (page 219)

41. Statement of Cash Flows (Not Covered!) Provides information about the cash receipts and cash disbursements of an enterprise that occurred during a period Cash refers to cash plus cash equivalents Presented for each period Helpful in assessing future profitability, liquidity, and long-term solvency LO4-7 Categories of transactions affecting cash Operating activities Investing activities Financing activities

42. Operating Activities Inflows and outflows of cash that result from activities reported in the income statement Net cash flows from operating activities: Difference between the inflows and outflows LO4-8 Operating Activities Cash Inflows Sale of goods or services Interest and dividends from investments Cash Outflows Purchase of inventory Salaries, wages, and other operating expenses Income taxes

43. Concept Check √ Which of the following items would not be included as a cash flow from operating activities in a statement of cash flows? a.Purchase of inventory. b.Purchase of machinery. c.Payment of income taxes. d.Collection of interest on a note. The purchase of machinery is an investing activity.

44. LO4-8 Direct and Indirect Methods of Reporting Direct Method Indirect Method Cash effect of each operating activity is reported directly in the statement Net cash flow is derived indirectly by starting with reported net income and adding or subtracting items to convert that amount to a cash basis Two generally accepted formats can be used to report operating activities:

45. LO4-8 Contrasting the Direct and Indirect Methods of Presenting Cash Flows from Operating Activities

46. Direct Method of Presenting Cash Flows from Operating Activities LO4-8

47. Concept Check √ Bledsoe Motors reported revenue of $7,500,000 for its year ended December 31, 2016. Accounts receivable at December 31, 2015 and 2016, were $480,000 and $532,500, respectively. Using the direct method for reporting cash flows from operating activities, Bledsoe Motors would report cash collected from customers of: a.$7,500,000. b.$7,552,500. c.$7,567,500. d.$7,447,700. $480,000 + 7,500,000 – 532,500 = $7,447,500

48. Indirect Method of Presenting Cash Flows from Operating Activities LO4-8

49. Concept Check √ Kringle Pastries reported net income of $432,000 for its year ended December 31, 2016. Purchases of merchandise totaled $304,000. Accounts payable balances at the beginning and end of the year were $72,000 and $66,000, respectively. Beginning and ending inventory balances were $88,000 and $92,000, respectively. Assuming that all relevant information has been presented, Kringle Pastries would report operating cash flows of: a.$310,000. b.$442,000. c.$422,000. d.$302,000. Net income Deduct increase in inventory Deduct decrease in account payable Cash flows from operating activities $432,000 (4,000) (6,000) $422,000

50. Investing Activities Include inflows and outflows of cash related to the acquisition and disposition of long-lived assets used in the operations of the business and investment assets Purchase and sale of inventories are not considered investing activities LO4-8

51. Investing Activities Cash outflows include cash paid for: o Purchase of long-lived assets used in the business o Purchase of investment securities like stocks and bonds of other entities o Loans to other entities Cash inflows: o The sale of long-lived assets used in the business o The sale of investment securities o The collection of a nontrade receivable (excluding the collection of interest, which is an operating activity) LO4-8 Other than those classified as cash equivalents and trading securities

52. Relate to the external financing of the company Financing Activities LO4-8 Financing Activities Cash Inflows From owners when shares are sold to them From creditors when cash is borrowed through notes, loans, mortgages, and bonds Cash Outflows To owners in the form of dividends or other distributions To owners for the reacquisition of shares previously sold To creditors as repayment of the principal amounts of debt (excluding trade payables that relate to operating activities)

53. Noncash Investing and Financing Activities Activities that do not involve cash flows at all Reported on the face of the statement of cash flows or in a disclosure note Example: Acquisition of equipment (an investing activity) by issuing either a long-term note payable or equity securities (a financing activity) LO4-8

54. Statement of Cash Flows (beginning with Net cash flows from operating activities) LO4-8

55. International Financial Reporting Standards LO4-9 U.S. GAAPIFRS Income Statement Presentation No minimum requirements.Require certain minimum information to be reported on the face of the income statement. SEC regulations require expenses be classified by function. Allow expenses to be classified either by function or by natural description. “Bottom line” of the income statement usually is called either net income or net loss. Description of the bottom line of the income statement is either profit or loss. Comprehensive Income Companies are allowed to report comprehensive income in either a single statement of comprehensive income or in two separate, but consecutive statements. Same as under U.S GAAP. Other comprehensive income items are similar under both standards. However, an additional OCI item, changes in revaluation surplus, is possible under IFRS.

56. International Financial Reporting Standards LO4-9 U.S. GAAPIFRS Classification of Cash Flows Cash outflows for interest payments and cash inflows from interest and dividends received as operating cash flows. Dividends paid to shareholders are classified as financing cash flows. Interest and dividends paid can be classified as either operating or financing cash flows and interest and dividends received as either operating of investing cash flows.

57. Interim Reporting Interim reports: Issued for periods of less than a year, typically as quarterly financial statements Appendix 4 Objectives To enhance the timeliness of financial information To provide investors and creditors with additional insight on the seasonality of business operations Downside Relative unreliability Intensified effect of unusual events

58. Interim Data in Annual Report—PetSmart, Inc. Appendix 4

59. Interim Reporting Reporting Revenues and Expenses: Most revenues and expenses are recognized using the same accounting principles applicable to annual reporting Most are recognized in interim periods as incurred An expenditure that benefits more than just the period in which it is incurred, should be allocated among the periods benefited Income tax expense at each interim date should be based on estimates of the effective tax rate for the whole year Appendix 4

60. Interim Reporting Reporting Unusual Items: Discontinued operations should be reported separately in the interim period in which they occur – Not allocated among individual quarters Appendix 4

61. Earning Per Share: – Quarterly EPS calculations follow the same procedures as annual calculations – Based on conditions actually existing during the particular interim period Reporting Accounting Changes: – Reported retrospectively by applying the changes to prior financial statements Interim Reporting Appendix 4

62. Requires only certain Minimum Disclosures: o Sales, income taxes, and net income. o Earnings per share. o Seasonal revenues, costs, and expenses. o Significant changes in estimates for income taxes. o Discontinued operations and unusual items. o Contingencies. o Changes in accounting principles or estimates. o Information about fair value of financial instruments and the methods and assumptions used to estimate fair values. o Significant changes in financial position. Interim Reporting Appendix 4

63. International Financial Reporting Standards LO4-9 U.S. GAAPIFRS Interim Reporting Costs are accrued or deferred and then charged to each of the periods they benefit. Requires that a company apply the same accounting policies in its interim financial statements as it applies in its annual financial statements. Costs are expensed entirely in the period in which they occur. Interim period income is less volatile than under IFRS. Interim period income is more volatile under IFRS than under U.S. GAAP. Income taxes are accounted for based on an estimate of the tax rate expected to apply for the entire year. Same as under U.S.GAAP.

64. End of Chapter 4