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2. Test Taking Info Review tomorrow Goal Order of questions Read again Exam structure “Cheat” sheet Review sheet / sample exam Misc Row assignment Caps Calculators Journal entry as destination
3. Chapter 4income statement and related informationSommers – Intermediate I
4. Discussion Question Q4-1 What kinds of questions about future cash flows do investors and creditors attempt to answer with information in the income statement? The income statement is important because it provides investors and creditors with information that helps them predict the amount, timing, and uncertainty of future cash flows. It helps investors and creditors predict future cash flows in a number of different ways. First, investors and creditors can use the information on the income statement to evaluate the past performance of the enterprise. Second, the income statement helps users of the financial statements to determine the risk (level of uncertainty) of income—revenues, expenses, gains, and losses—and highlights the relationship among these various components.
5. Income Statement Usefulness Evaluate past performance. Predicting future performance. Help assess the risk or uncertainty of achieving future cash flows.
6. Income Statement Limitations Companies omit items that cannot be measured reliably. Income is affected by the accounting methods employed. Income measurement involves judgment.
7. Discussion Question Q4-3 Identify at least two situations in which important changes in value are not reported in the income statement. Unrealized gains or losses on available-for-sale investments, Changes in the market values of long-term liabilities, such as bonds payable, Changes (increases) in value of property, plant and equipment, such as land, natural resources, or equipment, Changes (increases) in the values of intangible assets such as customer goodwill, brand value, or intellectual capital.
8. Discussion Question Q4-8 Why should caution be exercised in the use of the net income figure derived in an income statement? Caution should be exercised because many assumptions and estimates are made in accounting and the net income figure is a reflection of these assumptions. If for any reason the assumptions are not well-founded, distortions will appear in the income reported. The objectives of the application of generally accepted accounting principles to the income statement are to measure and report the results of operations as they occur for a specified period without recognizing any artificial exclusions or modifications.
9. Income Statement Quality of Earnings Companies have incentives to manage income to meet or beat Wall Street expectations, so that market price of stock increases and value of stock options increase. Quality of earnings is reduced if earnings management results in information that is less useful for predicting future earnings and cash flows.
10. Earnings Quality – Operating/Nonoperating Operating Income Restructuring Costs – Costs associated with shutdown or relocation of facilities or downsizing of operations are recognized in the period incurred. Goodwill Impairment and Long-lived Asset Impairment - Involves asset impairment losses or charges. Nonoperating Income Gains and losses from the sale of operational assets and investments - Often can significantly inflate or deflate current earnings. Example: As the stock market boom reached its height late in the year 2000, many companies recorded large gains from sale of investments that had appreciated significantly in value. How should those gains be interpreted in terms of their relationship to future earnings? Are they transitory or permanent?
11. Classification Where would the following items lie? Sales revenue Restructuring charges Royalty income Interest expense Payment made for settlement of lawsuit R&D expense Incentives for disclosures that influence user classification?
12. Discussion Question Q4-10 What is the major distinction (a) between revenues and gains and (b) between expenses and losses? The major distinction between revenues and gains (or expenses and losses) depends on the typical activities of the enterprise. Revenues can occur from a variety of different sources, but these sources constitute the entity’s ongoing major or central operations. Gains also can arise from many different sources, but these sources occur from peripheral or incidental transactions of an entity. The same type of distinction is made between expenses and losses.
13. Single-Step Format Single-Step Income Statement Revenues Expenses Net Income Single- Step No distinction between Operating and Non-operating categories.
14. Multiple-Step Format Multiple-Step Income Statement Separates operating transactions from nonoperating transactions. Matches costs and expenses with related revenues. Highlights certain intermediate components of income that analysts use.
15. Multiple-Step Format Intermediate Components of the Income Statement Operating section Nonoperating section Income tax Discontinued operations Extraordinary items Earnings per share
16. Multiple-Step Format The presentation divides information into major sections. 1. Operating Section 2. Nonoperating Section 3. Income tax
17. E4-7 The accountant of Weatherspoon Shoe Co. has compiled the following information from the company’s records as a basis for an income statement for the year ended December 31, 2014. Rent revenue $29,000 Interest expense 18,000 Market appreciation on land above cost 31,000 Salaries and wages expense (sales) 114,800 Supplies (sales) 17,600 Income tax 30,600 Salaries and wages expense (administrative) 135,900 Other administrative expenses 51,700 Cost of goods sold 516,000 Net sales 980,000 Depreciation on plant assets (70% selling, 30% administrative) 65,000 Cash dividends declared 16,000 There were 20,000 shares of common stock outstanding during the year. Prepare a multiple-step income statement.
18. E4-7
19. E4-7 Single Step
20. Income Statement Classifications
21. Reporting Irregular Items Irregular itemsfall into six categories Discontinued operations. Extraordinary items. Unusual gains and losses. Changes in accounting principle. Changes in estimates. Corrections of errors.
22. Reporting Irregular Items Companies are required to report irregular items in the financial statements so users can determine the long-run earning power of the company. Illustration 4-6 Number of Unusual Items Reported in a Recent Year by 500 Large Companies
23. Reporting Irregular Items Discontinued Operations Occurs when, (a) company eliminates the results of operations and cash flows of a component. there is no significant continuing involvement in that component. Amount reported “net of tax.”
24. Reporting Discontinued Operations Illustration:KC Corporation had after tax income from continuing operations of $55,000,000 for the year. During the year, it disposed of its restaurant division at a pretax loss of $270,000. Prior to disposal, the division operated at a pretax loss of $450,000 for the year. Assume a tax rate of 30%. Prepare a partial income statement for KC. Income from continuing operations $55,000,000 Discontinued operations: Loss from operations, net of $135,000 tax 315,000 Loss on disposal, net of $81,000 tax 189,000 Total loss on discontinued operations 504,000 Net income $54,496,000
25. Reporting Discontinued Operations Discontinued Operations are reported after “Income from continuing operations.” Previously labeled as “Net Income”. Moved to
26. P&G’s Income Statement
27. Reporting Irregular Items Extraordinary itemsare nonrecurring material items that differ significantly from a company’s typical business activities. Extraordinary Item must be both of an Unusual Nature and Occur Infrequently Company must consider the environment in which it operates. Amount reported “net of tax.”
28. Reporting Extraordinary Items Illustration:KC Corporation had after tax income from continuing operations of $55,000,000 during the year. In addition, it suffered an unusual and infrequent pretax loss of $770,000 from a volcano eruption. The corporation’s tax rate is 30%. Prepare a partial income statement for KC Corporation beginning with income from continuing operations. Income from continuing operations $55,000,000 Extraordinary loss, net of $231,000 tax 539,000 Net income $54,461,000 ($770,000 x 30% = $231,000 tax)
29. Reporting Irregular Items Reporting when both Discontinued Operations and Extraordinary Items are present. Discontinued Operations Extraordinary Items
30. Reporting Irregular Items Unusual Gains and Losses Material items that are unusual or infrequent, but not both, should be reported in a separate section just above “Income from continuing operations before income taxes.” Examples can include: Write-downs of inventories Foreign exchange transaction gains and losses The Board prohibits net-of-tax treatment for these items.
31. Reporting Irregular Items Unusual Gains and Losses Illustration 4-9 Income Statement Presentation of Unusual Charges
32. Special Reporting Issues Intraperiod Tax Allocation Relates the income tax expense to the specific items that give rise to the amount of the tax expense. Income tax is allocated to the following items: (1) Income from continuing operations before tax. (2) Discontinued operations. (3) Extraordinary items.
33. Intraperiod Income Tax Allocation Income Tax Expense must be associated with each component of income that causes it. Show Income Tax Expense related to Income from Continuing Operations. Report effects of Discontinued Operations and Extraordinary Items NET OF RELATED INCOME TAXES.
34. Special Reporting Issues Intraperiod Tax Allocation Extraordinary Gain: Schindler Co. has income before income tax and extraordinary item of $250,000. It has an extraordinary gain of $100,000 from a condemnation settlement received on one its properties. Assuming a 30 percent income tax rate. Illustration 4-13
35. Special Reporting Issues Intraperiod Tax Allocation Extraordinary Loss: Schindler Co. has income before income tax and extraordinary item of $250,000. It has an extraordinary loss from a major casualty of $100,000. Assuming a 30 percent income tax rate. Illustration 4-14
36. Example of Intraperiod Tax Allocation Note: losses reduce the total tax Calculation of Total Tax $24,000 (135) (61) (231) $23,573
37. Discussion Question Q4-12 What is the basis for distinguishing between operating and nonoperating items? Operating items are the expenses and revenues which relate directly to the principal activity of the concern; they are revenues realized from, or expenses which contribute to, the sale of goods or services for which the company was organized. The nonoperating items result from secondary activities of the company. They are not directly related to the principal activity of the company but arise from incidental activities.
38. Discussion Question Q4-30 On January 30, 2013, a suit was filed against Frazier Corp. under the EPA. On August 6, 2014, Frazier agreed to settle the action and pay $920,000 in damages to certain current and former employees. How should this settlement be reported in the 2014 financial statements? The damages would probably be reported in Frazier Corporation’s financial statements in the other expenses or losses section. If the damages are unusual in nature, the damage settlement might be reported as an unusual item. The damages would not be reported as a correction of an error (prior period adjustment).
39. Reporting Irregular Items Changes in Accounting Principles Changes in Estimate Corrections of Errors
40. Net income less preferred dividends Weighted-average number of common shares outstanding for the period Earnings Per Share Disclosure One of the most widely used ratios is earnings per share (EPS), which shows the amount of income earned by a company expressed on a per share basis. Basic EPS Diluted EPS Reflects the potential dilution that could occur for companies that have certain securities outstanding that are convertible into common shares or stock options that could create additional common shares if the options were exercised.
41. P&G’s Income Statement
42. Special Reporting Issues Earnings Per Share (BE4-8):In 2014, Hollis Corporation reported net income of $1,000,000. It declared and paid preferred stock dividends of $250,000. During 2014, Hollis had a weighted average of 190,000 common shares outstanding. Compute Hollis’s 2014 earnings per share. Net income - Preferred dividends Weighted average number of shares outstanding $1,000,000 - $250,000 = $3.95 per share 190,000
43. Special Reporting Issues Illustration 4-17 Divide by weighted-average shares outstanding EPS
44. Special Reporting Issues Retained Earnings Statement Increase Decrease Net income Change in accounting principle Error corrections Net loss Dividends Change in accounting principles Error corrections
45. Special Reporting Issues Restrictions on Retained Earnings Disclosed In notes to the financial statements. As Appropriated Retained Earnings.
46. Understanding Equity Beginning equity + Received from owners – Distributed to owners (other than dividends) – Dividends declared + Net income (or – net loss) + Other comprehensive income = Ending equity Contributed capital Retained earnings Comprehensiveincome On Income Statement Not on Income Statement Accum OCI If OCI = 0, earnings are “clean surplus” else they are “dirty surplus”.
47. Weird stuff Comprehensive Income An expanded version of income that includes four types of gains and losses that traditionally have not been included in income statements. Net unrealized holding gains (losses) from investments (net of tax). Gains and losses due to reviewing assumptions or market returns differing from expectations and prior service cost from amending the postretirement benefit plan. When a derivative is designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction. Gains or losses from changes in foreign currency exchange rates. The amount could be an addition to or reduction in shareholders’ equity.
48. Comprehensive Income Other Comprehensive Income Unrealized gains and losses on available-for-sale securities. Translation gains and losses on foreign currency. Plus others + Reported in Stockholders’ Equity
49. Accumulated Other Comprehensive Income In addition to reporting comprehensive income that occurs in the current period, we must also report these amounts on a cumulative basis in the balance sheet as an additional component of shareholders’ equity.
50. Special Reporting Issues Companies must display the components of other comprehensive income in one of three ways: A second separate income statement; A combined income statement of comprehensive income; or As part of the statement of stockholders’ equity
51. Special Reporting Issues Comprehensive Income Illustration 4-19 Second income statement LO 8
52. P&G’s Statement of Comprehensive Income
53. Special Reporting Issues Comprehensive Income Combined statement LO 8
54. Special Reporting Issues Comprehensive Income – Balance Sheet Presentation Illustration 4-21 Presentation of Accumulated Other Comprehensive Income in the Balance Sheet Regardless of the display format used, the accumulated other comprehensive income of $90,000 is reported in the stockholders’ equity section of the balance sheet.
55. IFRS Insights RELEVANT FACTS Presentation of the income statement under GAAP follows either a single-step or multiple-step format. IFRS does not mention a single-step or multiple-step approach. Extraordinary items are prohibited under IFRS. Under IFRS, companies must classify expenses by either nature or function. GAAP does not have that requirement, but the U.S. SEC requires a functional presentation. IFRS identifies certain minimum items that should be presented on the income statement. GAAP has no minimum information requirements. However, the SEC rules have more rigorous presentation requirements.
56. IFRS Insights RELEVANT FACTS IFRS does not define key measures like income from operations. SEC regulations define many key measures and provide requirements and limitations on companies reporting non-GAAP/IFRS information. Both GAAP and IFRS require companies to indicate the amount of net income attributable to non-controlling interest. GAAP and IFRS follow the same presentation guidelines for discontinued operations, but IFRS defines a discontinued operation more narrowly. Both standard- setters have indicated a willingness to develop a similar definition to be used in the joint project on financial statement presentation.
57. IFRS Insights RELEVANT FACTS Both GAAP and IFRS have items that are recognized in equity as part of comprehensive income but do not affect net income. GAAP provides three possible formats for presenting this information: single income statement, combined statement of comprehensive income, in the statement of stockholders’ equity. Most companies that follow GAAP present this information in the statement of stockholders’ equity. IFRS allows a separate statement of comprehensive income or a combined statement. Under IFRS, revaluation of property, plant, and equipment, and intangible assets is permitted and is reported as other comprehensive income. The effect of this difference is that application of IFRS results in more transactions affecting equity but not net income.