Chapter 4 Income Statement

1. Chapter 4Income Statement

2. Usefulness of Income Statement • Evaluate the past performance of the enterprise. • Provide a basis for predicting future performance. • Help assess the risk or uncertainty of achieving future cash flows.

3. Guidelines for Revenue Recognition The revenue recognition principle provides that revenue is recognized: • when it is earned, and • when it is realizedor realizable Revenue is earned when the earnings process is substantially complete. Revenue is realized when goods and services are exchanged for cash or claims to cash. Revenue is realizablewhen assets received are convertible into a known amount of cash.

4. Four Types of Revenue Transactions

5. Examples of Problems in Revenue Recognition • Gross vs. net basis of reporting revenue (middlemen as agent) • Barter transactions (Advertising swaps between internet companies) • Channel stuffing (end of period transactions, side agreements) • Misclassification of unusual/infrequent items as gross revenues. • Related party transactions recognized as third party transactions. • Selling undervalued assets to generate reportable gains (LIFO inventory dipping; sell of assets recently acquired in a business combination. • Deliberate misstatement of percentage of completion on long-term construction projects.

6. The Single Step Income Statement • Heading shows name of the entity, title of the statement and period of time covered • Major sections are Revenues and Expenses. • No distinction between operating and non-operating activities. • The Earnings Per Share amount is shown at the bottom of the statement.

7. Revenues Sales Other Revenues Revenues Expenses Cost of Goods Sold Selling & Admin. Exp. Interest Expense Income Tax Expense Expenses The Single Step Income StatementSee handout in class - +- Irregular Items Discontinued Operations (net of tax) Extraordinary Items (net of tax) Net Income Earnings per Share

8. The Multiple Step Income Statement • Heading shows name of the entity, title of the statement and period of time covered • The presentation divides information into major sections on the statement. • The statement distinguishes operating from non-operating activities. • Continuing operations are shown separately from irregular items. • The income tax effects are shown separately as well.

9. Sales Revenue less: Cost of Goods Sold less: Selling Expenses less: Administrative Expenses Operating Section 1 3 Income Tax 6 5 Earnings per Share Net Income The Multiple Step Income StatementSee handout in class Non-Operating Section 2 Add: Other Revenues and Gains Less: Other Expenses and Losses Discontinued Operations (net of tax) Extraordinary Items (net of tax) Irregular Items 4

10. Intra-period Tax Allocation • Tax expense for year related to specific items. • Used for: • Income from continuing operations • Discontinued operations • Extraordinary items

11. Unusual Gains and Losses • Items that are unusual or infrequent, but not both. • If material, disclose separately. • They should be presented as a separate component of income from continuing operations and are not presented net of taxes. • Examples: • Write-down of property plant and equipment • Loss from permanent impairment of the value of a distribution facility

12. Changes in Accounting Estimates • Accounting estimates will change as new events occur, more experience is acquired or additional information is obtained. • Changes in accounting estimates are accounted for in period of change and future periods.

13. Discontinued Operations(Shown net of tax) Discontinued operations refer to the disposal of a component of an entity classified as held-for-sale or has been disposed. To qualify the component involves: • a segment, subsidiary, reporting unit, or asset group whose operations and cash flows are clearly distinguished from the rest of the entity, operationally as well as for financial reporting purposes. • Income Statement Presentation • Discontinued operations (Note ZZ) • Income (loss) from operations of discontinued Division (Including (loss) on disposal of $XXXX) net of tax. • Note any gain on disposal is deferred to the period when the actual sale occurs. • subsequent operating losses for the discontinued operations classified as held-for-sale are recognized in the period in which they are incurred. When comparative statements are presented they should reflect the effect of discontinued operations.

14. Discontinued Operations • Income Statement – reported as discontinued operations for the current and comparative periods provided that: Operations and cash flows have been (or will be) removed from the entity’s ongoing operations • Balance Sheet – Component valued at current fair value less cost to sell. • Asset(s) that are classified as held for sale, and their related liabilities, are presented separately in the asset and liability sections of the balance sheet • Future Operating Losses –. no liability for future operating losses is recognized • Expenses - While classified as held for sale, the asset is not depreciated or amortized, although accrual of other related expenses such as rent or interest continue. • Future liabilities – Lease termination cost and employee severance plan cost related to exit or disposal activities recognized in periods when obligations to others exists, not necessarily in the period of commitment to a plan to dispose. • Contingencies- Changes in previously reported discontinued operations amount are reported in current period statements as discontinued operations.

15. Extraordinary Items(Shown net of tax) • Extraordinary items are nonrecurring material items that • differ significantly from typical activities • Extraordinary items must meet two tests: • 1) they must be unusual (may or may not be under management’s control) and • 2) they must be infrequent (would not reasonably be expected to recur in the foreseeable future) • The environment in which the business operates is of primary importance. • FAS 145 removes the assumption that gains/losses from early extinguishment of debt are extraordinary items. Must now consider the environment.

16. Extraordinary Items: what they are not • Losses from write-down or write-off of receivables, inventories, etc. • Gains and losses from exchange or translation of foreign currency • Gains and losses from the abandonment of property used in business • Effects of strike • Adjustments or accruals on long term contracts. • Losses & cost related to 9/11/01 events (EITF 01-10)

17. Extraordinary Items Presentation Income before extraordinary items …………………………………….$XXXX Extraordinary items (less applicable income taxes of $XX) (Note Y)…... XXXX Net Income $XXXX

18. Change in Accounting Principle An accounting change results when: • a new principle, different from the one in use, is adopted. • A change in depreciation methods is not a change in accounting principle • A change from FIFO to LIFO method of inventory costing is an example. • Retrospective adjustment made to the Retained Earnings at the beginning of the earliest period shown for comparative purposes. • When comparative statements are presented, adjustments should be made of the amounts on net income (and components thereof) and retained earnings balance for all of the periods included in the financial statements.

19. Earnings Per Share Earnings per shareis: • Computed as: Net Income less Preferred Dividends Weighted Average of Common Shares Outstanding • Disclosed on the income statement for all the major sections. • Is subject to dilution (reduction).

20. Retained Earnings Statement • Retained earnings are increased by net income and decreased by net loss and dividends for the year. • Corrections of errors in prior period financial statements are shown as prior period adjustments to the beginning balance in retained earnings. • Any part of retained earnings, appropriatedfor a specific purpose, is shown as restricted earnings.

21. Prior Period Adjustments FAS 16 defines prior period adjustments: • The correction of an error in the financial statements of a prior period • Adjustments that result from realization of income tax benefits of preacquisition operating loss carryforwards of purchased subsidiaries. • If the statements presented are for a single period, then the beginning balance in retained earnings is restated to reflect the effects of the correction or change. • When comparative statements are presented, adjustments should be made of the amounts on net income (and components thereof) and retained earnings balance for all of the periods included in the financial statements.

22. Comprehensive Income All changes in equity during a period, except those resulting from investments by or distributions to owners.

23. Other Comprehensive Income (OCI) • Foreign Currency adjustments • Economic hedges on net investment in foreign entity • Hedge of a forecasted foreign-currency denominated transaction • Minimum Pension Liability • Where additional liability exceeds unamortized prior service cost, the excess is reported in OCI. • Unrealized Gains and Losses on Certain Investments • Unrealized gains/losses from available-for-sale securities (AFS) • Unrealized holding gains/losses that result for debt security being transferred into the AFS category from HTM category. • Subsequent decreases or increases in the fair value of AFS securities previously written down as impaired. • A change in the market value of a future contract that qualifies as a hedge of an asset reported at fair value. • Gain and Losses on Cash Flow Hedging Derivative Instruments

24. Other Comprehensive Income Must be displayed as: • A separate statement of comprehensive income OR • Combined income statement and comprehensive income statement OR • Part of statement of stockholders’ equity