1. Intermediate Accounting October 12th, 2010
General Course Questions
Review & Discuss Income Statement, Acctg. Changes & Errors
A. Chapter 4 and Questions 3,4,6,7,17,23,24, BE 7 & 8
Exercises 4,5,8,13, CE 4-1 & 4-2
B. Chapter 17 BE 5 & 6, Exercise 6 & 7
C. Chapter 22 Questions 1,2,3,4,6,8,12,15,18, BE 4,5,7-10
Exercises 2 & 8
Assignments for Thursday, October 14th:
A. Chapter 4 questions 15,16, E 15, Problem 3, CA 4-7
B. DQ for Levitt and Brennan
4. Return & Discuss Quiz Chapters 1-3

2. Chapter 4, 17, 22 Learning Objectives
Understand the Income Statement uses & limitations
Understand Income Statement Options (Single step vs. Multiple Step) and Explain Required Reporting for:
A. Non-recurring items
B. Intra period Tax Allocation
C. EPS
Distinguish between Changes in Accounting Estimates, Error Corrections, Changes in Accounting Principles and how to handle and/or report for each
Learn how to prepare a Statement of RE & Stockholders’ Equity
Learn three Reporting options for “Other Comprehensive Income” and items causing it

3. Usefulness of the Income Statement
Relevant Information has Feedback or Predictive Value
Evaluate past performance.
Predicting future performance.
Help assess the risk or uncertainty of achieving future cash flows.

4. Limitations of the Income Statement
Do not report items that cannot be measured reliably. (ch 4 ?3)
Managers timing reporting of revenues, expenses, gains and losses to meet their incentives
Generally increase current NI which decreases future NI
Can also be used to decrease current NI in order to increase future NI (Smoothing, Cookie Jar Reserves)
Reported Income is affected by the accounting choices made. (Ch 4 ?4)
Income measurement involves management judgment and can lead to Earnings Management (Ch 4 ?s 6 & 7)

5. Income Statement Information
Lists the following for a firm over a period of time:
Operating (Ongoing) Activities :
Revenues & Expenses
Non-Operating (Incidental or Peripheral) Activities:
Gains &/or Losses
Non-recurring Items (Irregular Items):
Resulting from Discontinued Operations &/or Extraordinary Items
Net Income = (Revenues + Gains) – (Expenses + Losses)
US GAAP vs. IFRS:
IFRS requires at least one year of comparative data on income statement (IAS 7)
US GAAP has no specific requirement (however, SEC rules require firms to report 3 years of income statement data)

6. Single-Step Income Statement
The single-step statement consists of just two groupings:
Revenues
Expenses
Net Income
Single- Step
No distinction between Operating and Non-operating categories.
Ch 4 ex 4

7. Multi-Step Income Statement
The presentation divides information into major sections.
1. Operating Section
2. Nonoperating Section
3. Income tax

8. Multi-Step Income Statement Presentation
I. Operating Section:
Information about the businesses operating activity
Used as basis for extrapolating into the future
May include unusual gains and losses
II. Non-operating or “Other” Section:
Interest expense and revenue
Other gains and losses (sale of fixed assets, etc.)
III. Income Tax Section (on above items)
IV. Non- recurring (Irregular) Items Section: presented “Net of Tax”
Discontinued operations (net of tax)
Extraordinary items (net of tax)

9. Reporting Unusual and Non-Operating Gains or Losses
Material gains or losses that are generally unusual or infrequent, but not both. The company must consider the environment in which it operates.
Do not qualify as “extraordinary”
Reported in Continuing Operations (above the line) in either the operating or non-operating section Managers exercise discretion in presentation above the line.
Examples:
A. Restructuring charges
B. Write downs or write off of Inventory, Receivables or Intangible items
C. Effects of a strike
D. Gains or Losses on Sale or Abandonment of PP&E

10. Non-recurring Items require separate disclosure on the Income Statement
Non-recurring items that occur during an accounting period must be disclosed separately on an income statement because they should not be used to predict future performance.
Recurring items could happen again.
Nonrecurring items are not expected to happen again; but need to be reported in the year they happen. GAAP limits “nonrecurring” to:
Discontinued Operations – when a business disposes of a major segment of business
Extraordinary Items
Gains or losses that are BOTH unusual and infrequent
page 12

11. Income Tax Disclosure
Recurring items – income tax expense is shown as a separate line item. Typically the last expense before calculating “income from continuing operations.”
Nonrecurring items – the income tax effect of a nonrecurring gain or loss is included in the calculation of the gain or loss. The gain or loss is shown “net of tax.”

12. Taxes Always Reduce the Nonrecurring Item
Assume a company with a 25% tax rate has as a:
Nonrecurring gain of $100,000. The gain would add to the company’s taxable income and cause them to pay $25,000 in taxes on the gain. The gain is thus, $_________ net of tax:
$100,000 – (25% x $100,000).
Nonrecurring loss of $100,000. The loss would lower the company’s taxable income. The reduction in taxes caused by the loss results in a smaller loss. The loss would be $_________ net of tax.

13. Non- recurring or Irregular Items
Reporting when both Discontinued Operations and Extraordinary Items are present.
Previously labeled as “Net Income”.
Discontinued Operations
Extraordinary Item
Ch 4 Ex 5

14. Reporting Extraordinary Items
Extraordinary items must meet BOTH of the following criteria:
Event/transaction must be unusual in nature.
Event/transaction must occur infrequently.
Items are reported “net of tax” (i.e. “below the line”).
Items that are NOT Extraordinary Items under GAAP:
Losses from write-down or write-off of receivables, inventories, etc.
Gains and losses from:
Exchange or translation of foreign currency
Disposal of a segment of a business
Abandonment of property used in business
Effects of strike
Adjustments or accruals on long term contracts
Extraordinary Item classification not allowed under IFRS

15. 4. Non-recurring Section, net of tax
Income Statement with Recurring & Non-Recurring Items
1. Operating Section
2. Other or Non-operating Section
3. Income tax (on recurring items)
4. Non-recurring Section, net of tax
Ch 4 ?17 ex 4,5,8,

16. Earnings Per Share
An important business indicator measuring the dollars earned by each share of Common Stock
Firms required to disclose both Basic and Fully Diluted EPS on the Income Statement
Basic EPS
Diluted EPS (when stock equivalents and convertible securities are outstanding, i.e. options, warrants, convertible P.S. or debt)

17. Earnings Per Share Computed as: Net Income less Preferred Dividends
Weighted Average of Common Shares Outstanding
Disclosed on the I/S for all the major sections:
Income from continuing operations
Discontinued operations loss, net of tax
Income before extraordinary item
Extraordinary item, net of tax
Net income

18. Earnings Per Share
Divide by weighted-average shares outstanding
EPS

19. Earnings Per Share Example: Assume Net Income of $5K
Preferred Stock Dividends = $1K
12/31/10 year-end
Outstanding common shares as follows:
1/1/10: 100 shares
4/1/10: 200 shares
7/1/10: 250 shares
Weighted Average Calculation:
100 x 3/12 = 25
200 x 3/12 = 50
250 x 6/12 = 125
Total wtg ave. 200 shares
Or months = 100
Add’l 100 9/ = 75
Add’l 50 for 6/12 = 25
Total wtg ave shares
Ch 4 ? 23, 24 & BE 8

20. Earnings Per Share
Example: At 12/31/06 Shi Corp. had the following stock outstanding:
10% cumulative preferred stock, $100 par, 107,500 shares $10,750,000
Common stock, $5 par, 4,000,000 shares ,000,000
During 2007, Shi Corp. did not issue any additional common stock. The following also occurred during 2007:
Income from continuing operations before taxes $23,650,000
Discontinued operations (loss before taxes) $ 3,225,000
Preferred dividends declared $ 1,075,000
Common dividends declared $ 2,200,000
Effective tax rate %
Compute EPS as it should appear on the 2007 f/s.
Income from continuing operations before taxes $23,650,000
Less income taxes 35% ( 8, 277, 500)
Income from Con’t Ops $15, 372,500
less Preferred dividends 10% $ 1,075,000
Income available to C.S $14,297,500
Loss on Disct Op net of tax ($3,225,000 x 65%) ($ 2,096,250)
Net Income $13,276,250
Income from con’t Op $14,297,500/4million shares = $3.574
Discontinued Op ($ 2,096,250)/4 million shares = (.524)
Net Income $13,276,250
less Preferred dividends 10% $ 1,075,000
Income available to C.S. $12,201,250
EPS $3.05
Discontinued Op ($ 2,096,250)/4 million shares = (.524)
Net Income $3.05
Common dividends declared $ 2,200,000
Effective tax rate %
Income from continuing operations
Discontinued operations loss, net of tax
Income before extraordinary item
Extraordinary item, net of tax
Net income

21. Accounting Changes Categories of Accounting Changes:
Change in Accounting Estimate
Accounting Errors in Financial Statements
Change in Accounting Principle

22. Accounting Changes What possible ways can we handle these changes? 1.2. 3.

23. Change in Accounting Estimate
Application of certain accounting concepts requires estimates:
Matching concept requires an estimate of the life of long-lived assets
Examples: uncollectible accounts, warranty liabilities, depreciation.
Estimates updated as new information becomes available.
Reporting:
Reported prospectively.
Change reported in current and future periods
No effect on prior periods (not considered an error)
Reported in the affected accounts, NOT “below the line”
(not considered an extraordinary item)

24. Change in Accounting Estimate
Example of prospective treatment:
Purchase machine on 1/1/09 for $110,000 with an estimated useful life of 10 years and a salvage value of $10,000.
Due to technological changes in 2010, it is estimated that the machine will have zero salvage value and will only have a useful life of 4 years beyond Annual depreciation for 2010 and beyond will be:
Depreciation taken in 2009 $110,000 – 10,000 salvage = $100,000 depreciable cost spread over 10 years $10,000 Depr taken 1st year
Undepreciated cost $100,000 / 5 years including or $20,000 per year

25. Accounting Errors and Prior Period Adjustments
Includes:
Change from an accounting principle that is not GAAP to GAAP or mistake in application of an accounting principle
Mathematical mistakes
Changes in estimate that occurs because estimates not prepared in good faith or facts used in error
Oversights (ex: failure to accrue or defer expenses and revenues at end of period)
Reporting:
Reported retrospectively as a “restatement”
Correct error in year(s) originally made by a direct entry to the affected line item(s). In following years the effect flows through beginning R/E. If error prior to years presented, adjust beginning R/E.
Errors from previous periods do not flow through current period income.

26. Accounting Errors and Prior Period Adjustments
Example: ABC company’s auditor found the following errors during the 12/31/10 audit. What is the impact of each error? Assume ABC is public.
At the end of 2009, sales salaries of $45,000 were not accrued.
In 2010, the company wrote off $87,000 of inventory considered to be obsolete; this loss was charged directly to Retained Earnings and credited to inventory.
2007 depreciation was understated by $100,000. Subsequent years’ depreciation was correctly recorded
Record Salaries Expense on prior year Income Stmt, reducing income and Beg RE
was likely recorded as Salary expense in 2010 when paid, thus reduces salary exp in 2010 and increases 2010 income
Should be recorded in Continuing operations of either in Operating or Other reducing this years income, no net affect on RE
Adjust RE at the Beg of 2008, no details on three comparative statements this year (2008, 2009 and 2010)

27. Change in Accounting Principle
Company adopts different accounting principle from the one previously used
Change from one acceptable method to another OR change in accounting standards. Examples?
If among acceptable methods, must demonstrate that newly adopted principle is preferable to the old one since such changes mean consistency across periods is lost.
Reporting since 5/15/05: SFAS154 adopts retroactive approach unless it is impracticable to do so.
Prior years’ statements presented in the financial statements are recast on a basis consistent with the newly adopted principle.
Adjust beginning retained earnings for the earliest year presented to reflect any cumulative effect on periods prior to those presented.
Note no cumulative effect is reported on the Income Statement
EXAMPLES: Stock options. Change in inventory pricing from FIFO to average costing). Change from % of completion to completed contract
NOTE: Pre 2005 reporting – Current approach was used. Cumulative effect of the change reported “below the line” with discontinued operations and extraordinary items. Prior years’ statements were not restated.
WHAT IS “Retroactive approach”?
Retrospectively (Restatement). Adjust prior years’ statements that are presented in the financial statements to reflect the newly adopted principle. Record any cumulative effect as an adjustment to beginning R/E for earliest period presented.

28. Change in Accounting Principle
Example: (ch 4 ex 13) Zehms Co. began operations in 2008 and adopted weighted average pricing for inventory. In 2010, Zehms changed to FIFO pricing. The pretax income data is:
Year Weighted Ave. FIFO
, ,000
, ,000
, ,000
Assume a 35% tax rate in all years.
a) What is NI in 2010?
b) Compute the cumulative effect of the change in accounting principle from weighted average to FIFO pricing.
c) Show comparative income statements for Zehms Co., beginning with income before income tax, as presented on the 2010 income statement.
EXERCISE 4-13 (15–20 minutes)
(a)
Income before income tax $460,000
Income tax (35%) ,000
Net Income $299,000
(b) Cumulative effect for years prior to 2010:
Year Weighted FIFO Difference Tax Rate Net Effect
Average %
$370, $395, $25,000 
, , ,000 
Total , $19, $35,750
(c)     2010        2009        2008    
Income before income tax $460,000 $420,000 $395,000
Income tax (35%) , , ,250
Net income $299,000 $273,000 $256,750

29. Retained Earnings Statement
Increased by net income and decreased by net loss and dividends for the year.
Prior period adjustments to beginning balance
Corrections of errors in prior period financial statements
cumulative impact of changes in accounting principles
Any part of retained earnings appropriated for a specific purpose is shown as restricted earnings.
So dividends can’t be paid out from restricted R/E (can be part of a debt covenant)
Ch 4 ex 8

30. Retained Earnings Statement
Increased by:
Decreased by:
Net income
Cumulative Affect of a Change in accounting principle
Error corrections (Prior Period Adj.)
Net loss
Dividends
Cumulative Affect of a Change in accounting principles
Error corrections (Prior Period Adj)
Restricted Retained Earnings Disclosed in the Notes and Financial Statements as Appropriated Retained Earnings not available for Dividends.

31. Comprehensive Income Overview
What is comprehensive income?
All changes in equity during a period, except those resulting from investments by or distributions to owners.
Includes “regular” net income
PLUS “other comprehensive income”:
(Results from unrealized change in Fair Mkt Value)
unrealized gains or losses on available for sale securities (Ch17)
unrealized gains or losses on foreign currency translation
unrealized gains or losses on pension obligations
unrealized gains or losses from incomplete hedging transactions

32. Unrealized Holding Gains/Losses on Securities
Why do companies invest in debt and equity securities?
< 20% interest assume little or no influence over investee
Report debt intending to hold at “held to maturity”
Record investment at amortized cost
Record interest as income
Report equity & other debt investment using fair value method
Mark investment to “market” on B/S.
Recognize unrealized gain or loss. Where depends upon classification
Trading  Income Statement
Available-for-Sale  Other comprehensive income
Other issues
Can calculate gain or loss at the portfolio level
Potential for earnings management here?

33. Reporting Comprehensive Income
Companies are required to report total
comprehensive income in one of three ways:
On the face of its Income Statement (combined statements)
In a separate Statement of Comprehensive
Income, or
3. In the Statement of Stockholders’ Equity (most companies choose this option)
May present net of tax or before tax with a single line reporting taxes on comprehensive income
Do E4-14, E4-15

34. Reporting Comprehensive Income on the Income Statement
Regular Income Statement
“Other Comprehensive Income”

35. Reporting Comprehensive Income on a second Statement

36. Reporting Comprehensive Income in a Statement of Stockholders’ Equity

37. Unrealized Gains/Losses
Example: on 1/1/09 Big bought shares of Little for $100,000. The shares were < 20% of the total outstanding stock of Little Company. On 12/31/09 the shares had a fair value of $125,000. Little paid dividends of $1000 to Big. How is this accounted for at 1/1/09 and 12/31/09?
If classified as Trading Securities?
If classified as Available for Sale Securities?