1. CHAPTER 6
THE INCOME STATEMENT 15 15

2. Introduction
Various groups are affected by, and have a stake in, the financial reporting requirements of the FASB and the SEC 16 16

3. Introduction
Investors in equity securities are the central focus of the financial reporting environment 16 16

4. Introduction Investing involves for future uncertain resources.
giving up current resources
for future uncertain resources.
Therefore, investors require information assessing future cash flows. 16 16

5. The Economic Consequences of Financial Reporting
Financial reporting has economic consequences including:
Financial information can affect the distribution of wealth among investors.
More informed investors, or investors employing security analysts, may be able to increase their wealth at the expense of less informed investors. 17 17

6. The Economic Consequences of Financial Reporting
Financial information can affect the level of risk accepted by a firm.
Focusing on short-term, less risky, projects may have long-term detrimental effects.
Financial information
can affect the rate of capital formation in the economy
and result in a reallocation of wealth between consumption and investment within the economy. 17 17

7. The Economic Consequences of Financial Reporting
Financial information can affect how investment is allocated among firms.
These economic consequences may have a differential impact on different user groups and future deliberations of standards must consider these economic consequences 17 17

8. Elements of the Income Statement
SFAC No. 1 indicates that the primary focus of financial reporting is to provide information about a company’s performance
The income statement reports on performance and the elements of the income statement were defined in SFAC No. 6 as:
Revenues
Gains
Expenses
Losses 18 18

9. Each Term Is Defined As Changes in Assets and Liabilities
Differences between changes in assets approach and inflow and outflow definition are:
Change in net economic resources
Measure of effectiveness 1. VS 2.
Definition of Assets and Liabilities
Earnings VS
Revenue & Expenses
Creation of deferred charges when measuring income
Recognition when they are economic resources or obligations 3. VS 19 19

10. Each Term Is Defined As Changes in Assets and Liabilities4.
Both agree on importance of income statement
The change in asset approach limits the population from which elements can be selected to net economic resources.
The flows method includes items necessary to match 5. VS 19 19

11. Statement Format
The preparation of the income statement has been impacted by differences of opinion on the definition of ongoing operations.
Two views:
All inclusive
Current operating performance 20 20

12. Current Income Statement Format
Proscribed in APB Opinion No. 9 as:
Revenues
Less: Cost of goods sold
= Gross profit
Less: Administrative and selling expenses
Plus: Other gains
Less: Other losses
= Income from continuing operations
Discontinued operations
Extraordinary items
Change in accounting principle
= Net income 21 21

13. Income From Continuing Operations
Normal and recurring revenues and expenses
Sustainable income
Income tax
Nonrecurring items
Discontinued operations
Extraordinary items
Change in accounting principle

14. Tootsie Roll and Hershey’s
Tootsie Roll Industries and The Hershey Company are internationally known candy manufacturers.
We will use information from the two companies’ fiscal annual reports to illustrate the disclosure of information in this and subsequent chapters.

15. Discontinued Operations
Why special treatment?
Arise from a disposal of a segment of a business
Comprised of two elements
Gain or loss on disposed assets
Gain or loss on operations during the disposal periods
When to report
Measurement date
Disposal date
Neither Hershey’s nor Tootsie Roll disclosed any discontinued operations for fiscal years 44 44

16. SFAS No. 144 Changed reporting of discontinued operations:
Unit must qualify as a component (distinguishable assets and cash flows
Operations and cash flows of component must be eliminated
Company does not retain any significant involvement in operations of component
Neither Hershey or Tootsie Roll disclosed any discontinued operations

17. Extraordinary Items Original definition Problems
APB No. Opinion No. 30
Unusual nature
Infrequency of occurrence
Problem:
Requirements do not always separate recurring and non-recurring items
As a result, there is a tendency to increase the variability of operating income and decrease the predictive ability of earnings
The events of 9/11
Neither company discloses any extraordinary items for the years presented 22 17 22

18. Accounting Changes
The accounting standard of consistency requires that similar transactions should be reported similarly each year
Occasionally an entity may find that reporting needs are better served by changing a method of accounting
If so, the comparability of financial statements is impaired
Basic question: Should previously issued financial statements be amended? 29 18

19. Types of Accounting Changes
Change in accounting principle
How reported
APB Opinion No 20
SFAS No 154
Hershey’s CAP was due to a change in the method of accounting for special purpose entities as required by the FASB
Change in accounting estimate
How reported
Change in accounting entity
Error 30 30 19

20. Earnings Per Share Basic calculation APB No. 15
Net income - Preferred dividends Average # of common shares outstanding
APB No. 15
Simple vs. complex capital structure
Required calculation of primary and fully diluted earnings per share
Criticism of APB No. 15
The FASB and IASC project 24 24

21. SFAS No. 128 Reasons for the change
Basic EPS and diluted EPS data would give users the most factually range of possibilities
Use of a common international method is important due to the data based oriented financial analysis and internationalization of business
The notion of common stock equivalents does not operate efficiently in practice
The computation of primary EPS is complex and not well understood or consistently applied
Presenting basic EPS eliminates criticism about the arbitrary nature of the determination of common stock equivalents 25

22. SFAS No. 128
Requires presentation of EPS by all publicly traded companies issuing common stock
Companies with a simple capital structure will only report basic earnings per share. All others will report basic and diluted
Calculation of basic EPS
Net income - Preferred dividends Average # of common shares outstanding 26

23. Diluted Earnings Per Share
Objective
Historical - basic
Pro forma - diluted
Calculation:
Includes all potential dilutive securities
Options and warrants - treasury stock method
Convertible securities
Continently issuable securities 27

24. Usefulness of EPS
Objectives of EPS reporting are to provide investors an indication of :
Value of the firm
Expected future dividends
Question: Historical or forecasted?
Summary indicator
Both Best Buy and Circuit City have complex capital structure
disclose basic as well as diluted earnings per share on their their fiscal income statements 28

25. SFAC No. 5 - Recognition and Measurement
Comprehensive income definition:
The change in net assets of an entity from non-owner transactions
Attempts to combine Hicksian capital maintenance approach with traditional accounting transactions approach 31

26. SFAC No. 5 - Recognition and Measurement
A full set of financial statements shall show:
Comprehensive income
Investments by and distributions to owners
Financial position
Earnings
Cash flows 32

27. SFAS No. 5 - Recognition and Measurement
Comprehensive income
Revenues Earnings
Less: Expenses Plus or minus cumulative accounting adjustments
Plus: Gains Plus or minus other nonowner changes in equity
Less: Losses
= Earnings = Comprehensive income 33 33

28. Measurement Issues Definitions. Measurability. Relevance. Reliability.
The item meets the definition of an element contained in SFAC No. 6.
Measurability.
It has a relevant attribute, measurable with sufficient reliability.
Relevance.
The information about the item is capable of making a difference in user decisions.
Reliability.
The information is representationally faithful, verifiable, and neutral. 34 34

29. SFAS No 130 - Reporting Comprehensive Income
Reasons for the initial project
Off-balance sheet financing
The practice of reporting some items of comprehensive income in stockholders’ equity
Acknowledged need for harmonization of accounting standards 35

30. Definitions Comprehensive income Other comprehensive income
the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from nonowner sources.
Other comprehensive income
revenues, expenses, gains, and losses included in comprehensive income but excluded from net income. 36 36

31. SFAS No 130 - Reporting Comprehensive Income
Original issues:
Should comprehensive income be reported?
Should cumulative accounting adjustments be included in comprehensive income?
How should the components of comprehensive income be classified for disclosure?
How should comprehensive income be disclosed in the financial statements?
Should the components of other comprehensive income be disclosed before or after their related tax effects? 37

32. Should Comprehensive Income Be Reported?
SFAS No 130
Requires the disclosure of comprehensive income and
Discusses how to report and disclose comprehensive income and its components, including net income.
Does not specify when to recognize or how to measure components 38 38

33. Should Cumulative Accounting Adjustments Be Included?
As Part Of
Cumulative Accounting Adjustments
Comprehensive Income
Cumulative Accounting Adjustments 39 39

34. How Should the Components of Comprehensive Income Be Classified for Disclosure?
Requirement:
Companies must disclose an amount for net income
That amount must be accorded equal prominence with the amount disclosed for comprehensive income
Items of other comprehensive income are classified based on their nature 40 40

35. How Should Comprehensive Income be Disclosed in the Financial Statements?
Requires a gross disclosure technique for items of other comprehensive income
Allows for the disclosure of comprehensive income
On income statement
On a separate statement
On the statement of stockholders’ equity 41 41

36. Should Components of Other Comprehensive Income Be Displayed Before or After Their Related Tax Effects.
Allows the components of other comprehensive income to be disclosed either
Net of related tax effects or
Before related tax effects with one amount shown for the aggregate income tax expense or benefit related to the total amount of other comprehensive income
Other comprehensive income is transferred to a separate component of stockholders’ equity
Hershey’s discloses changes in other comprehensive income in its consolidated statement of shareholders’ equity as a single net amount.
Tootsie Roll includes the calculation of other comprehensive income on its income statement. 42 42

37. Prior Period Adjustments
An adjustment to beginning retained earnings balance
Original criteria in APB No. 9
Examples were income tax disputes and litigation
SEC Staff Bulletin No. 8 and APB Opinion No. 16
Correction of an error
Adjustments from realization of operating loss carryforward of purchased subsidiary 23 23

38. Financial Performance Reporting by Business Enterprises
In 2001 FASB initiated a project to redesign the income statement.
This project termed Financial Performance Reporting by Business Enterprises has two main objectives:
To improve the quality of information disclosed in financial statements to that investors, creditors and other interested parties are able to better evaluate an enterprise’s financial performance
To ascertain that the financial statements provide sufficient information to permit the calculation of key financial performance measures.

39. Financial Performance Reporting by Business Enterprises
While no final conclusions had been drawn when this book was published, some tentative decisions have been offered:
A single statement of comprehensive income should be prepared that reports all items of revenue, expense, gains and losses.
The statement of comprehensive income should report three major categories
Business activities
Financing
Other
Income tax expense should be reported separately after the categories.
Income from continuing operations should be disclosed as a subtotal
Discontinued operations are to be presented as a separate classification net of their tax effects after income tax expense.
Other comprehensive income is also presented
The cumulative effect of a change in accounting principle is included in other comprehensive income.
Extraordinary items will be reported in the appropriate major category before tax and will not be labels as extraordinary.

40. The Value of Corporate Earnings
The financial analysis of a company’s income statement focuses on a company’s operating performance by focusing on such questions as:
What are the company’s major sources of revenue?
What is the persistence of a company’s revenues?
What is the company’s gross profit ratio?
What is the company’s operating profit margin?
What is the relationship between earnings and the market price of the company’s stock?

41. Sources of Revenue domestic international
The financial analysis of a diversified company requires a review of the impact of various business segments on the company as a whole.
Hershey’s reports segmental information for two segments:
domestic
international
Tootsie Roll reports segmental information for two segments:
Neither company discloses any information about major customers.

42. Persistence of Revenues

43. Management’s Discussion and Analysis
The MD&A section of a company’s annual report can provide valuable information on the persistence of a company’s earnings and its related costs.
SEC requires companies to disclose any changes or potential changes in revenues and expenses to assist in the evaluation of period-to-period deviations.
Examples of these disclosures include
unusual events
expected future changes in revenues and expenses
the factors that caused current revenues and expenses to increase or decrease
trends not otherwise apparent from a review of the company’s financial statements
An expanded discussion of the MD&A section of the annual report is contained in Chapter 17.

44. Gross Profit Percentage = Gross profit ÷ net sales
Gross Profit Analysis
Gross Profit Percentage = Gross profit ÷ net sales

45. Net Profit Percentage = Net Income ÷ Net Sales
Net Profit Analysis
Net Profit Percentage = Net Income ÷ Net Sales

46. The Value of Corporate Earnings
The relationship between corporate earnings and stock prices
Measured by price earnings ratio
Hershey’s = 26.69
Tootsie = 20.09
Net Profit Percentage = Net Income ÷ Net Sales

47. International Accounting Standards
International Accounting Standards Committee has:
Defined the concepts of performance and income in “Framework for the Preparation and Presentation of Financial Statements”
Discussed the content and format of the income statement in IAS No. 1, “ Presentation of financial Statements”
Discussed some components of the income statement in an amended IAS No. 8, now titled "Accounting Policies, Changes in Accounting Estimates and Errors"
Defined the concept of revenue in IAS No. 18, “Revenue”
Amended IAS No. 33
Discussed the required presentation and disclosure of a discontinued operation in IFRS No. 5, “Non-Current Assets Held for Sale and Discontinued Operations” 46

48. IASC Definitions of Performance and Income
Profit is used
to measure performance
or as the basis for other measures
Measurement of income is dependent on
the concept of capital maintenance used by the enterprise
Physical capital maintenance
Financial capital maintenance 47

49. IASC Definitions of Performance and Income
The IASC definition of income encompasses both revenue and expenses
The IASC has not made the distinction between ordinary and nonordinary operations contained in SFAC No. 6
A proposed standard would require a “Statement of Non-owner Movements in Equity”
Encourages an analysis of income and expenses based on their nature or function in the enterprise 48

50. IAS No. 1: Presentation of Financial Statements
Requires an operating/non operating separation and disclosure of the following components of income:
Revenue
Results of operating activities
Finance costs
Income from associates and joint ventures
Taxes
Profit or loss from ordinary activities
Extraordinary items
Minority interest
Net profit or loss
FASB Staff Reaction

51. IAS No. 8: Accounting Policies, Changes in Accounting Estimates and Errors
Originally, IAS No. 8
defined the concepts of
net profit or loss from ordinary activities
extraordinary items
accounting changes
fundamental errors
Each of these income statement items was defined and reported in a manner similar to U.S. GAAP
with the exception of fundamental errors
The revised IAS No. 8
does not distinguish between ordinary and extraordinary items
eliminates the concept of fundamental errors 49

52. IAS No. 8: Accounting Policies, Changes in Accounting Estimates and Errors
A GAAP hierarchy indicates that the following sources must be applied in descending order of authoritativeness:
International Financial Reporting Standard, including any appendices that form part of the Standard
Interpretations
Appendices to an IFRS that do not form part of the Standard
Implementation guidance issued by IASB in respect of the Standard

53. IAS No. 8: Accounting Policies, Changes in Accounting Estimates and Errors
Now defined as newly discovered omissions or misstatements of prior period financial statements based on information that was available when the prior financial statements were prepared
All material errors will be accounted for retrospectively
by restating all prior periods presented
and adjusting the opening balance of retained earnings of the earliest prior period presented
Cumulative effect recognition in income is prohibited
FASB Staff Reaction

54. IAS No. 18 - Revenue Revenue should be recognized when:
The enterprise has transferred to the buyer the significant risks and rewards of ownership of goods
The enterprise doesn’t retain managerial involvement or control over the goods sold
The amount can be measured reliably
It is probable that economic benefits associated with the transaction will flow to the enterprise
The costs associated with the transaction can be measured reliably 50

55. IAS No. 18 - Revenue FASB Staff Reaction
U. S. GAAP does not specifically address the issue of revenue
If it did, there would probably be a difference because of the IASC use of the term probable future economic benefit
FASB Staff Reaction 50

56. IAS No. 35: Discontinued Operations
The amended IAS No. 33 incorporated the following additional disclosures and guidelines:
Basic and diluted EPS must be presented for
(a) profit or loss from continuing operations and
(b) net profit or loss
…on the face of the income statement for each class of ordinary shares, for each period presented.
Potential ordinary shares are dilutive only when their conversion to ordinary shares would decrease EPS from continuing operations
(IAS 33 previously used net income as the benchmark).

57. IAS No. 35: Discontinued Operations
For contracts that may be settled in cash or shares, now includes a rebuttable presumption that the contract will be settled in shares.
If an entity purchases (for cancellation) its own preference shares for more than their carrying amount, the excess (premium) should be treated as a preferred dividend in calculating basic EPS (deducted from the numerator of the EPS computation).
Guidance is provided on how to calculate the effects of contingently issuable shares; potential ordinary shares of subsidiaries, joint ventures, or associates: participating securities; written put options; and purchased put and call options.

58. IFRS No. 5: Non-Current Assets Held for Sale and Discontinued Operations
SFRS No. 5 replaces IAS No. 35.
Discontinued operations
Post-tax profit or loss of the discontinued operation
Post-tax gain or loss recognized on the measurement to fair value
Cost to sell or fair value adjustments on the disposal of the assets (or disposal group) - +
Should be presented as a single amount on the face of the income statement

59. IFRS No. 5: Non-Current Assets Held for Sale and Discontinued Operations
Detailed disclosure of revenue, expenses, pre-tax profit or loss, and related income taxes is required
either in the notes or on the face of the income statement in a section distinct from continuing operations.
Such detailed disclosures must cover both the current and all prior periods presented in the financial statements.
IFRS No 5 prohibits the retroactive classification as a discontinued operation, when the discontinued criteria are met after the balance sheet date.

60. Prepared by Richard Schroeder, PhD Kathryn Yarbrough, MBA
End of Chapter 6
Prepared by Richard Schroeder, PhD Kathryn Yarbrough, MBA
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