1. 1 The Income Statement and Statement of Cash Flows C hapter 4 An electronic presentation by Douglas Cloud Pepperdine University An electronic presentation by Douglas Cloud Pepperdine University

2. 2 1.Understand the concepts of income. 2.Explain the conceptual guidelines for reporting income. 3.Define the elements of an income statement. 4.Describe the major components of an income statement. 5.Compute income from continuing operations. ObjectivesObjectives ContinuedContinued

3. 3 6.Compute results from discontinued operations. 7.Identify extraordinary items. 8.Prepare a statement of retained earnings. 9.Report comprehensive income. 10.Explain the statement of cash flows. 11.Classify cash flows as operating, investing, or financing. ObjectivesObjectives

4. 4 Concepts of Income 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.

5. 5 Assume a corporation has net assets of $50,000 at the beginning and $90,000 at the end of the year, and that no additional investments or withdrawals were made. Ending net assets$90,000 Less: Additional investment 0 Ending net assets excluding investment$90,000 Less: Beginning net assets(50,000) Total income for the year$40,000 The corporation could pay out $40,000 to stockholders and still be as well off at year-end. Concepts of Income Capital Maintenance Concept

6. 6 Assume a corporation has net assets of $45,000 at the beginning and $80,000 at the end of the year. Stock- holders made additional capital investments of $10,000. Ending net assets$80,000 Less: Additional investment(10,000) Ending net assets excluding investment$70,000 Less: Beginning net assets(45,000) Total income for the year$25,000 Concepts of Income Capital Maintenance Concept

7. 7 Transactional Approach Under this concept, a company records its net assets at their historical cost, and it does not record changes in the asset and liabilities unless a transaction, event, or circumstance has occurred that provides reliable evidence of a change in value. The transactional approach to income measurement is used in accounting today. Concepts of Income

8. 8 Transactional Approach Concepts of Income A corporation’s net income for an accounting period currently is measured as follows: Net income = Revenues – Expenses + Gains - Losses

9. 9 Conceptual Reporting Guidelines 1.Providing information about its operating performance separately from other aspects of performance. 2.Presenting the results of particularly significant activities or events that predict the amounts, timing, and uncertainty of its future income and cash flows. 3.Providing information useful for assessing the return on investment. The FASB suggests that a company’s income statement can be improved by-- ContinuedContinued

10. 10 Conceptual Reporting Guidelines 4.Providing feedback that enables users to assess their previous predictions of income and its components. 5.Providing information to help assess the cost of maintaining its operating capability. 6.Presenting information about how effectively management has discharged its stewardship responsibilities regarding the company’s resources.

11. 11 Specific Conceptual Guidelines 1.Those items that are judged to be unusual in amount based on past experience should be reported separately. 2.Revenues, expenses, gains, and losses that are affected in different ways by changes in economic conditions should be distinguished from one another. 3.Sufficient detail should be given to aid in understanding the primary relationships among revenues, expenses, gains, and losses. Guidelines about how to report revenues, expenses, gains, and losses. ContinuedContinued

12. 12 Specific Conceptual Guidelines 4.When the measurements of revenues, expenses, gains, or losses are subject to different levels of reliability, they should be reported separately. 5.Items whose amounts must be known for the calculation of summary indicators (e.g., rate of return) should be reported separately.

13. 13 Revenues are inflows of assets of a company or settlement of its liabilities during a period... RevenuesRevenues … from delivering or producing goods, rendering services, or other activities that are the company’s ongoing major or central operations.

14. 14RevenuesRevenues Revenue recognition is the process of formally recording and reporting an item in a company’s financial statements.

15. 15RevenuesRevenues A company usually recognizes revenue at the time goods are sold or services are rendered.

16. 16ExpensesExpenses Expenses are outflows of 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.

17. 17 Cost: Asset or Expense Transaction Cost ContinueContinue If a cost results in an economic resource providing future benefits, record it as an... Asset

18. 18 Cost: Asset or Expense If a cost is a result of providing goods or services in a time period, record it as an... Expense Transaction Cost

19. 19 Cost: Asset or Expense If the benefits have been used up, the asset is changed to an expense.

20. 20 Income Statement Content a.Sales revenue (net) b.Cost of goods sold c.Operating expenses d.Other items e.Income tax expense related to continued operations a.Sales revenue (net) b.Cost of goods sold c.Operating expenses d.Other items e.Income tax expense related to continued operations 1. Income from continuing operations

21. 21 Income Statement Content 2. Results from discontinued operations a.Income (loss) from operations of discontinued significant components (net of income taxes). b.Gain (loss) from disposals of discontinued significant components (net of income taxes). a.Income (loss) from operations of discontinued significant components (net of income taxes). b.Gain (loss) from disposals of discontinued significant components (net of income taxes).

22. 22 3.Extraordinary items (net of income taxes) 4.Cumulative effects of changes in accounting principles (net of income taxes) 5.Net income 6.Earnings per share Income Statement Content

23. 23 Cost of Goods Sold: BANNER CORPORATION Schedule 1: Cost of Goods Sold For Year Ended December 31, 2004 Inventory, January 1, 2004$ 41,000 Purchases$80,300 Freight-in 5,500 Cost of purchases$85,800 Less: Purchases returns (2,800) Net purchases 83,000 Cost of goods available for sale$124,000 Less: Inventory, December 31, 2004 (38,000) Cost of goods sold$ 86,000 Merchandising Company

24. 24 Cost of Goods Sold: BANNER CORPORATION Schedule 1: Cost of Goods Sold For Year Ended December 31, 2004 Raw materials used$ 35,000 Direct labor29,000 Factory overhead Depreciation of factory items $5,100 Heat, light, and power4,000 Indirect factory labor7,300 Repairs and maintenance3,400 Miscellaneous factory expense1,200 21,000 Current manufacturing costs$ 85,000 Manufacturing Company ContinuedContinued

25. 25 Cost of Goods Sold Cost of Goods Sold: Current manufacturing costs$ 85,000 Add: Goods in process, January 1, 200427,000 Less: Gods in process, December 31, 2004 (29,000) Cost of goods manufactured$ 83,000 Add: Finished goods inventory, Jan. 1, 2004 41,000 Cost of goods available for sale$124,000 Less: Finished goods inventory, December 31, 2004 (38,000) Cost of goods sold$ 86,000

26. 26 Income Tax Expense 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.

27. 27 Income Tax Expense 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.

28. 28 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.Cumulative effect of any change in accounting principles 6.Any prior period adjustments 7.Any items of other comprehensive income Income Tax Expense Income tax expense is matched against the following:

29. 29 Single-Step Income Statement Revenues Sales revenue$143,700 Interest revenue1,800 Dividend revenue 600 Total revenues$146,100 Expenses Cost of goods sold$ 86,000 Selling expense10,200 General and admin. expense16,000 Depreciation expense7,800 ContinuedContinued

30. 30 Expenses (continued) Loss on sale of equipment4,000 Interest expense2,100 Income tax expense 6,000 Total expenses(132,100) Income from continuing operations$ 14,000 Results from discontinued operations Income from operations of significant component A (net of $1,950 income taxes)$ 4,550 Loss on disposal of significant component A (net of $3,150 income tax) (7,350) (2,800) Income before extraordinary items $ 11,200 ContinuedContinued

31. 31 Income before extraordinary items$ 11,200 Extraordinary loss from explosion (net of $750 income tax credit)(1,750) Cumulative effect on prior years’ income of change in depreciation method (net of $600 income taxes) 1,400 Net income$ 10,850 Earnings per Common Share (8,000 shares) Components of Income Income from continuing operations$ 2.80 Results from discontinued operations(0.56) Extraordinary loss from explosion(0.35) Cumulative effect on prior years’ income 0.28 Net income$2.17

32. 32 Income Statement: Results from Discontinued Operations Examples from APB No. 30 The sale by a diversified company of a major division that represented the company’s only activities in the electronic industry.

33. 33 Income Statement: Results from Discontinued Operations The sale by a meat packing company of its 20% interest in a professional football team. Examples from APB No. 30

34. 34 Income Statement: Results from Discontinued Operations FASB Statement No. 142 A component of a company involves operations and cash flows that can be clearly distinguished, operationally and for the financial reporting purposes, from the rest of the company.

35. 35 Income Statement: Results from Discontinued Operations Income from continuing operations$93,000 Results from discontinued operations: Income from operations of discontinued Division X (net of $2,880 income taxes)$ 6,720 Loss on disposal of Division X (net of $6,000 income tax credit)(14,000) (7,280) Income before $85,720 Reported net of taxes

36. 36 Note that discontinued operations are reported on the income statement after the continuing operations, but before extraordinary items. Income Statement: Results from Discontinued Operations

37. 37 Income from continuing operations$93,000 Results from discontinued operations: Income from operations of discontinued Division X (net of $2,880 income taxes)$ 6,720 Loss on disposal of Division X (net of $6,000 income tax credit)(14,000) (7,280) Income before extraordinary items$85,720 Income Statement: Results from Discontinued Operations Component 1: operating income (loss)

38. 38 Component 2: gain or loss on disposal Income from continuing operations$93,000 Results from discontinued operations: Income from operations of discontinued Division X (net of $2,880 income taxes)$ 6,720 Loss on disposal of Division X (net of $6,000 income tax credit)(14,000) (7,280) Income before extraordinary items$85,720 Income Statement: Results from Discontinued Operations

39. 39 Income Statement: Results from Discontinued Operations On September 30, 2004 Duvall Company sells Division C (a component of its operations) for $102,000 and incurs $2,000 of legal fees and closing costs. At the time of the sale, the book values of Division C’s assets and liabilities are $150,000 and $80,000, respectively. Duvall Company is subject to a 30% income tax rate. Sale Illustration ContinuedContinued

40. 40 Net cash received ($102,000 – $2,000)$100,000 Book value of net assets of Division C: Assets$150,000 Liabilities (80,000) Net book value (70,000) Pretax gain$ 30,000 Income tax (30%) (9,000) After-tax gain$ 21,000

41. 41 FASB Statement No. 144 requires that all of the following criteria be met to qualify for “held for sale”: 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. 4.The sale is probable within one year. 5.The component is being marketed 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

42. 42 Income Statement: Results from Discontinued Operations Elmo Company classifies Division M as “held for sale” at the end of 2004. Elmo Company expects to sell Division m in 2005 and estimates the fair value of the division is $200,000. At the end of 2004, the book value of Division M is $240,000. The company is subject to a 30% income tax rate. Held-for-Sale Illustration ContinuedContinued

43. 43 Fair value of Division M$200,000 Book value of net assets of Division M: Assets$330,000 Liabilities (90,000) Net book value (240,000) Pretax loss$ (40,000) End of 2004 Loss on Write-Down of Held-For-Sale Division M (pretax)40,000 Assets of Division M40,000

44. 44 Income Statement: Results from Discontinued Operations Disclosures Required by FASB Statement No. 144 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 of discontinued operations section of the company’s income statement. ContinuedContinued

45. 45 Income Statement: Results from Discontinued Operations Disclosures Required by FASB Statement No. 144 If not reported separately 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.

46. 46 Gain or Loss on Sale On September 30, 2004 Duvall Company sells Division C (a significant component of its operations) for $102,000 and incurs $2,000 of legal fees and closing costs. At the time of the sale, the book values of Division C’s assets and liabilities are $150,000 and $80,000, respectively. Duvall Company is subject to a 30% income tax rate. ContinuedContinued

47. 47 Net cash received ($102,000 - $2,000)$100,000 Book value of net assets of Division C: Assets$150,000 Liabilities (80,000) Net book value (70,000) Pretax gain$ 30,000 Income tax (30%) (9,000) After-tax gain$ 21,000

48. 48 Sale in a Later Accounting Period When a company classifies a significant 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.

49. 49 To review the criteria that must be met under FASB Statement No. 144 for a significant component to be considered “held for sale” click on the button below. To return to the example (Slide 50), click on the “held for sale” banner at the bottom of the review slide. To skip the review, simply press the Enter key. Go to review

50. 50 Sale in a Later Accounting Period Elmo Company classifies Division M (a significant component of its operations) as “held for sale” at the end of 2004. Elmo Company expects to sell Division M in 2005 at its fair value of $200,0000 (consisting of assets with a fair value of $300,000 and liabilities with a fair value of $100,000). At the end of 2004, the book value of Division M is $240,000 (assets book value, $330,000; liabilities book value, $90,000). The company is subject to a 30% income tax rate. ContinuedContinued

51. 51 Fair value of Division M$200,000 Book value of net assets of Division C: Assets$330,000 Liabilities (90,000) Net book value (240,000) Pretax loss$ (40,000) End of 2004 Loss on Write-Down of Held-For-Sale Division M (pretax)40,000 Liabilities of Division M10,000 Assets of Division M30,000

52. 52 Extraordinary Items An extraordinary item is an event or transaction that is both unusual in nature and infrequent in occurrence. 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. Infrequency of occurrence—the underlying event or transaction is of a type that is not reasonably expected to recur in the foreseeable future.

53. 53 1.The write-down or write-off of receivables, inventories, equipment leased to others, or intangible assets. 2.Gains or losses from exchanges or transactions of foreign currency. 3.Gains or losses from the disposals of a business component. Extraordinary Items Events that the APB Opinion No. 30 identified as not qualifying as extraordinary: ContinuedContinued

54. 54 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 effect of a terrorist attack. Extraordinary Items Events that the APB Opinion No. 30 identified as not qualifying as extraordinary:

55. 55 Extraordinary Items One other item is required to be reported as an extraordinary item. As prescribed by FASB Statement No. 141, when a company purchases another company and pays less than the fair value of the other company, it reports the difference as an extraordinary gain.

56. 56 Extraordinary Items Unusual? No Report Gain (Loss) As Income from Continuing Operation (Other Items section) Infrequent? No or Income from Continuing Operation (Other Items section) Event

57. 57 Extraordinary Items Event Unusual? No Report Gain (Loss) As Infrequent? No or Yes Yes and Extraordinary Item

58. 58 Change in Accounting Principle A change in accounting principle occurs when a company adopts a generally accepted accounting principle different from the one it has been using in its financial reporting. In most instances, a company reports the cumulative effect on prior years’ earnings in its net income for the year in which it makes the change.

59. 59 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.

60. 60 Statement of Retained Earnings Retained earnings is the link between a corporation’s balance sheet and its income statement.

61. 61 Statement of Retained Earnings Beginning retained earnings$59,200 Plus (minus): Prior period adjustment (net of $2,400 income taxes) 5,600 Adjusted beginning retained earnings$64,800 Plus (minus): Net income (loss) 22,300 $87,100 Minus: Dividends (specifically identified, including per share amounts) (9,400) Ending retained earnings$77,700

62. 62 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. Currently, there are four items of a company’s other comprehensive income: ContinuedContinued

63. 63 1.Any unrealized increases (gains) or decreases (losses) in the market value of investments in available-for-sale securities. 2.Any change in the excess of its additional pension liability over unrecognized prior service costs. 3.Certain gains and losses on “derivative” financial instruments. 4.Any transaction adjustment from converting the financial statements of a company’s foreign operations into U. S. dollars. Comprehensive Income

64. 64  On the face of its income statement.  In a separate statement of comprehensive income.  In its statement of changes in stockholders’ equity. Comprehensive Income The FASB allows a company to report its comprehensive income under three alternatives: The company must display the statement containing the comprehensive income as a major financial statement in its annual report.

65. 65 Comprehensive Income In reporting its comprehensive income, a company must add its other comprehensive income to 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.

66. 66 Statement of Cash Flows The company’s ability to generate positive future cash flows. The company’s ability to meet its obligations and pay dividends. The company’s need for external financing. The reasons for differences between the company’s net income and associated cash receipts and payments. Both the cash and noncash aspects of the company’s investing and financing transactions. The statement of cash flows helps users to assess--

67. 67 Statement of Cash Flows Operating activities include all the transactions and other events related to its earnings process. Investing activities include all the transactions involving acquiring and selling long-term investment, acquiring and selling property, plant, and equipment, and lending money and collecting on loans. Financing activities include all the transactions involved in obtaining and disbursing resources from and to owners and repaying the amounts borrowed.

68. 68 Statement of Cash Flows The statement of cash flows includes three major sections. (1) Net cash flow from operating activities. (2)Cash flows from investing activities. (3)Cash flows from financing activities.

69. 69 To eliminate certain amounts that were included in net income but that did not involve a cash inflow or cash outflow for operating activities. To include any changes in the current assets (other than cash) and current liabilities involved in the company’s operating cycle that affect cash flow differently than net income. Statement of Cash Flows In the Net Cash Flows from Operating Activities section, net income is listed first and then adjustments are made to net income (indirect method)--

70. 70 Receipts from selling investments in stocks and debt securities. Receipts from selling property, plant, and equipment. Payments for investments in stocks and debt securities. Payments for purchases of property, plant, and equipment. Statement of Cash Flows The Cash Flows From Investing Activities section includes all the cash inflows and outflows involved in investing activities transactions of the company. Common investing activities are--

71. 71 Receipts from the issuance of debt securities. Receipts from the issuance of stocks. Payment of dividends. Payments to retire debt securities. Payments to reacquire stock. Statement of Cash Flows The Cash Flows From Financing Activities section includes all the cash inflows and outflows involved in the financing activities transactions of the company. Common financing activities are--

72. 72 C hapter 4 The End

73. 73