chapter 4 income statement - wordpress.com · the comprehensive income and statement of...

4-1

1. The concept of income

2. Why income measure is important

3. How income is measured

4. The format of an income statement

5. The components of an income statement

6. The comprehensive income and statement of

stockholders’ equity

7. Simple forecasts of income for future periods

Chapter 4 Income Statement

4-2

What It Is and What It Isn’t

• Income is not equal to the amount of cash

generated from the successful operation of the

business.

• Income is a return over and above the

investment.

• It is the amount that an entity could return to

its investors and still leave the entity as well-

off at the end of the period as it was at the

beginning.

1. Define the concept of income

4-3

Financial Capital Maintenance Concept of

Income Determination

The financial capital maintenance concept

assumes that a company has income “only if

the dollar amount of an enterprise’s net

assets at the end of the period exceeds the

dollar amount of net assets at the beginning

of the period after excluding the effects of

transactions with owners.

(continued)

4-4

Beginning

of Period

End of

PeriodTotal assets $510,000 $560,000

Total liabilities 430,000 390,000

Net assets

(owners’ equity) $ 80,000 $170,000

Income is $90,000

Kreidler, Inc. had the following assets and

liabilities at the beginning and at the end of a

period.

(continued)



4-5

Net assets, end of period $170,000

Net assets, beginning of period 80,000

Change (increase) in net assets $ 90,000

Deduct investment by owners (40,000)

Add dividends to owners 15,000

Income $ 65,000

If the owners invested $40,000 in the business

and received dividends of $15,000, what would

be the income?



4-6

• Income per physical capital maintenance

occurs only if physical production capacity at

the end of the period exceeds the physical

production capacity at the beginning of the

period.

• This concept requires that productive assets

be valued at fair market value.

• Productive capital is maintained only if the

current costs of these capital assets are

maintained.

Physical Capital Maintenance Concept of


4-7

Practical Difficulties

a) Difficulty in estimating depreciation lives

b) Difficulty in implementing internal control

procedures

c) Difficulty in providing cash flow information

d) Difficulty in obtaining fair market values of

assets and liabilities

The FASB adopted the financial capital maintenance

concept as part of the conceptual framework.

Physical Capital Maintenance Concept of


4-8

Why is a Measure of Income Important?

The recognition, measurement, and reporting

(display) of business income and its

components are considered by many to be the

most important tasks of accountants. For

example:

• Has the activity been profitable?

• What is the trend of profitability?

• Is it increasing profitable, or is there a

downward trend?

2. Explain why an income measure is important

4-9

In the United States, the FASB has specified

that financial accounting information is

designed with investors and creditors in mind,

while at the same time recognizing that many

other groups will find the resulting information

useful as well.

Accrual-based financial accounting

information is not suited for every

possible use.

(continued)


4-10

• In code law countries, such as Germany and

Japan, accounting standards have

historically been set by legal processes.

• In a common law country, such as the United

States and the United Kingdom, accounting

standards are set in response to market

forces.


4-11

Transaction Approach

• To provide detail concerning the components of income, accountants have adopted a transaction approach to measuring income that stresses the direct computation of revenues and expenses.

• The transaction approach, sometimes referred to as the matching method, focuses on business events that effect certain elements of the financial statements.

2. Explain how income is measured, including

the revenue recognition and expense-

matching concepts

4-124-12

4-13

Revenue and Gain Recognition

• Under GAAP of accrual accounting, revenue

recognition does not necessarily occur when

cash is received.

• Revenues and gains are recognized when:

1. they are realized or realizable, and

2. they have been earned through substantial

completion of the activities involved in the

earnings process.

(continued)

4-14

Revenue and Gain Recognition

• Revenues are recognized when the company

generating the revenue has provided the bulk

of the goods or services it promised for the

customer and when the customer has provided

payment or at least a valid promise of payment

to the company.

• In order for revenue to be recognized,

inventory or other assets must be exchanged

for cash or claims to cash, such as accounts

receivable.

4-15

1. If a market exists for a product so that its sale

at an established price is practically ensured

without significant selling effort, revenue may

be recognized at the point of completed

production.

(continued)

Earlier Recognition

4-16

2. If a product or service is contracted for in

advance, revenue may be recognized as

production takes place, or as services are

performed, especially if the production or

performance period extends over more than

one fiscal year.

Earlier Recognition

4-17

Later Recognition

If collectability of assets received for products or

services is considered doubtful, revenues and

gains may be recognized as the cash is

received.

The installment sales and cost recovery

methods of accounting have been developed to

recognize revenue under these conditions.

Sales of real estate, especially speculative

recreational property, are often recorded using

this variation of the general rule.

4-18

Direct Matching

• Relating expenses to specific revenues is

often referred to as the matching process.

• For example, shipping costs and sales

commissions usually relate directly to

revenues.

• Certain expenses have to be estimated to be

matched against recognized revenue for the

period.

(continued)

Expense and Loss Recognition

4-19

• Direct expenses include not only those that

already have been incurred but also include

anticipated expenses related to revenues of

the current period.

• Costs of collection, bad debt losses from

uncollectible receivables, and possible

warranty costs should be estimated and

matched against recognized revenue for the

period.


4-20

Systematic and

Rational Allocation

The cost of assets that benefit more

than one period, such as buildings,

equipment, patents, and prepaid

insurance, are spread across the

periods of expected benefit in some

systematic and rational way.


4-21

Immediate Recognition

• Many expenses are not related to specific

revenues but are incurred to obtain goods

and services that indirectly help to

generate revenues.

• Examples include office salaries, utilities,

and general advertising. These are

recognized as expenses in the period in

which they are incurred.


4-22

Gains and Losses from Changes

in Market Values

• An exception to the transaction approach in

the recognition of gains and losses arises

when gains or loss are recognized in the

wake of changes in market value.

• When a long-term asset, such as a building,

has decreased substantially in value (an

impairment), a loss is recognized even

though the building has not been sold and no

transaction has occurred.

4-23

Form of the Income Statement

• Traditionally, the income from the continuing

operations category has been presented in

multiple-step form.

• Using this format, the income statement is

divided into separate sections, and various

subtotals reflect different levels of profitability.

(continued)

4. Understand the format of an income

statement

4-24(continued)

4-24

4-254-25

4-26

Techtronics Corporation

For discussion purposes, the multiple-step

income statement for Techtronics Corporation

will be used. This statement is shown in

Exhibit 4-6 on Slides 4-26 and 4-27.

(continued)

4-27(continued) 4-27

4-284-28

4-29

Form of the Income Statement

• Comparative financial statements

present several years’ financial statements

side by side. This enables users to analyze

performance over multiple periods and

identify significant trends.

• Consolidated financial statements

combine the financial results of the “parent

company” with other companies that it owns,

called subsidiaries.

4-30

Income from Continuing Operations

1. Revenue

2. Cost of goods sold

3. Operating expenses

4. Other revenues and gains

5. Other expenses and losses

6. Income taxes on continuing operations

(continued)

5. Describe the specific components of an

income statement

4-31

Gross profit =

(Revenue – Cost of goods sold)

Operating income =

(Gross profit – Operating expenses)

Determining Subtotals

(continued)


4-32

Income from continuing operations before taxes

(Operating income + Other revenues and gains

– Other expenses and losses)

Income from continuing operations (Income from

continuing operations before income taxes –

Income taxes on continuing operations)

Determining Subtotals

(continued)


4-33

Revenue

• Revenue reports the total sales to

customers for the period less any sales

returns and allowances or discounts.

• Sales returns and allowances and sales

discounts should be subtracted from gross

sales revenue in arriving at net sales

revenue.(continued)


4-34

Cost of Goods Sold

Beginning inventory

+ Net purchases

+ Freight-in

+ Other inventory acquisition costs

= Cost of goods available for sale

– Ending inventory

= Cost of goods sold

(continued)


4-35

• Cost of goods sold is a significant item on

merchandising and manufacturing companies’

income statements.

• A manufacturing company has three

inventories rather than one: raw materials,

goods in process, and finished goods.

Cost of Goods Sold

(continued)


4-36

• Revenue from net sales – Cost of goods sold

= Gross profit

• Gross profit percentage is computed by

dividing gross profit by revenue from net

sales.

• The gross profit percentage provides a

measure of profitability that allows

comparisons for a firm from year to year.

Gross Profit

(continued)


4-37

If a company is not generating enough from

the sale of a product or service to cover the

costs directly associated with that product or

service, the company will not be able to stay

in business for long.

(continued)


4-38

Operating Expenses

Operating expenses may be reported in two

parts:

• Selling expenses

Sales salaries and commissions

Related payroll taxes

Advertising and store displays

Store supplies used

Depreciation on store furniture

(continued)


4-39

• General and administrative expenses

Officers’ and office salaries

Related payroll taxes

Office supplies used

Telephone, business licenses, etc.

Depreciation on office furniture

(continued)


4-40

Operating income measures the

performance of the fundamental business

operations conducted by a company.

Operating Income

Gross profit

– Operating expenses

= Operating income

(continued)


4-41

This section usually includes items

identified with the peripheral activities of the

company:

• Rent revenue

• Interest revenue

• Dividend revenue

• Gains from the sale of assets

Other Revenues and Gains

(continued)


4-42

This section parallels “Other Revenues and

Gains” except the items result in deductions

from operating income:

• Interest expense

• Losses from the sale of assets

(continued)

Other Expenses and Losses


4-43

Income Taxes on Continuing

Operations

• Income tax expense is the sum of all the

income tax consequences of all transactions

undertaken by a company during a year.

• The separation of income taxes into different

sections of the income statement is referred

to as intraperiod income tax allocation.

(continued)


4-44

Transitory, Irregular, and

Extraordinary Items

• These items arise from transactions and

events that are not expected to continue to

impact reported results in future years.

• Two types of transactions and events are

reported in this manner: (1) discontinued

operations and (2) extraordinary items.


4-45

Discontinued Operations

• The operations and cash flows of the

component must be clearly distinguishable

from other operations and cash flows of the

company, both physically and operationally,

as well as for financial reporting purposes.

• For example, discontinued operations

would result if a company closed one of five

product lines in a plant which tracks its

cash flows and income separately.

To report discontinued operations:

(continued)

4-46

• The component may be unprofitable.

• The component may not fit into the long-

range plans for the company.

• Management may need funds to reduce

long-term debt or to expand into other areas.

• Management may be fearful of a corporate

takeover by new investors desiring to gain

control of the company.

Why Discontinue?

(continued)

4-47

• Thom Beard Company has two divisions, A

and B. The operations and cash flows of these

two divisions are clearly distinguishable, and

so they both qualify as business components.

• On June 20, 2013, Thom Beard decides to

dispose of the assets and liabilities of Division

B. The revenues and expenses for Thom

Beard for 2013 and for the preceding two

years are shown in Slide 4-48.

(continued)

Reporting Requirements for Discontinued

Operations

4-48

During the later part of 2013, Thom Beard

disposed of a portion of Division B and recognized

a pretax loss of $4,000 on the disposal. Assume a

tax rate of 40%. The comparative income

statements appear on Slide 4-49.

4-48(continued)


Operations

4-494-49(continued)


Operations

4-50

Discontinued Operations

• The reporting requirements for discontinued

operations are contained in FASB ASC Subtopic

205.

• On the balance sheet, assets and liabilities

associated with discontinued components that have

not been completely disposed of as of the balance

sheet date are to be listed separately in the asset

and liability sections of the balance sheet.

• In addition to the summary income or loss amount

reported in the income statement, the total revenue

associated with the discontinued operations should

be disclosed in the financial statement notes.

4-51

International Accounting for Discontinued

Operations

According to IFRS 5, companies with

discontinued operations must disclose the

following:

• The amount of revenue, expenses, and

pretax profit or loss attributed to the

discontinued operations and related income

tax expense.

• A separate disclosure of the assets, liabilities,

and cash flows of the discontinued

operations. (continued)

4-524-52

In complying with Financial Reporting Standard

(FRS) 3 of the Accounting Standards Board in

the United Kingdom, British Telecommunications

provided the following information in its 2002

profit and loss account (income statement).

International Accounting for Discontinued

Operations

4-53

Extraordinary Items

Extraordinary items are events and

transactions that are both unusual in nature

and infrequent in occurrence. Thus, they

must contain “a high degree of abnormality

and be of a type clearly unrelated to, or only

incidentally related to, the ordinary and

typical activities of the entity . . . [and] be of a

type that would not reasonably be expected

to recur in the foreseeable future. . .”¹ ¹Opinions of the Accounting Principles Board No. 30, “Reporting the

Results of Operations (NY: AICPA, 1973), par. 20.

(continued)

4-54

Not Extraordinary

• The write-down or write-off of receivables,

inventories, equipment leased to others, etc.

• The gains or losses from exchange or

remeasurement of foreign currencies

• The gains or losses on disposal of business

segment

• Other gains or losses from sale or abandonment

of productive assets

• The effects of a strike

• Adjustment of accruals on long-term contracts

(continued)

4-554-55

4-56

Changes in Accounting Principles

• The conditions of some occasions justify a

change from one accounting principle to another.

• Occasionally a company will change an

accounting principle because a change in

economic conditions suggests that an accounting

change will provide better information.

• More frequently, a change in accounting principle

occurs because the FASB issues a new

pronouncement requiring a change in principle.

• To improve compatibility, income statements for

all years presented must be restated using the

new accounting method.

4-57

Changes in Accounting Principles

In 2013, Brandoni Company decided to change its method

of computing cost of goods sold from FIFO to LIFO. The

following sales and cost of goods sold information are for

2011-2013.

The 2013 comparative income statements for Brandoni

Company are shown below.

4-58

Changes in Estimate

• In reporting periodic revenues and in

attempting to properly match those expenses

incurred to generate current-period revenues,

accountants must continually make judgments.

• Estimates are required for such factors as the

number of years of useful life for depreciable

assets, the amount of uncollectible accounts

expected, and the amount of warrant liability to

be recorded on the books.

• No retroactive adjustments.

(continued)

4-59

Changes in Estimate

• Springville Manufacturing Co. Inc.,

purchased a milling machine at a cost of

$100,000. It was estimated to have a useful

life of 10 years and no salvage value. The

company uses straight-line depreciation.

• At the beginning of the fifth year, conditions

indicated that the machine would be used

only three more years.

• The schedule on Slide 4-60 summarizes

the charges over the life of the asset.

(continued)

4-60

Changes in Estimate

4-61

Effects of Changing Prices

Accountants have traditionally ignored this

phenomenon, especially when gains would result

from recognition. McDonald’s used the following

approach in its 10-K filed with the SEC.

4-62

Net Income or Loss

Income or loss from continuing operations

combined with the results of discontinued

operations and extraordinary items provides a

summary measure of the firm’s performance

for a period: net income or net loss.

4-63

Return on Sales

In order to compare the period’s results with prior

periods or with the performance of other firms,

net income is divided by net sales to determine

the return on sales.

4-63

4-64

Earnings per share =

Income from continuing operations

Weighted average number of shares of

common stock outstanding

Earnings Per Share

• Earnings per share amounts are computed for

income from continuing operations and for each

unusual or extraordinary item.

• If necessary, companies display basic and diluted

earnings per share.

When presenting earnings-per-share figures:

4-65

The price-earnings (P/E) ratio expresses the

market value of common stock as a multiple of

earnings and allows investors to evaluate the

attractiveness of a firm’s common stock.

Market value per share

Earnings per shareP/E ratio =

(continued)

Price-Earnings (P/E) Ratio

4-664-66(continued)

4-67

In general, the following types of firms have higher

than average P/E ratios:

• Firms with strong future growth possibilities

• Firms with earnings for the year lower than

average because of a nonrecurring event

• Firms with substantial unrecorded assets

Price-Earnings (P/E) Ratio

In general, the following types of firms have lower

than average P/E ratios:

• Firms with earnings for the year higher than

average because of a nonrecurring event

• Firms perceived as being very risky

4-68

Comprehensive Income

• Comprehensive income is the number used to

reflect an overall measure of the change in a

company’s wealth during the period.

• In addition to net income, it includes items that

arise from changes in market conditions unrelated

to the business operations of a company.

• Most companies include a report of

comprehensive income as part of the statement of

stockholders’ equity.

6. Compute comprehensive income and

prepare a statement of stockholders’

equity.

4-71

(concluded)

4-71

4-72

Comprehensive Income

Three of the more common adjustments

made in arriving at comprehensive

income are:

• Foreign currency translation

adjustments

• Unrealized gains and losses on

available-for-sale securities

• Deferred gains and losses on

derivative financial instruments

4-73

Proposed New Income Statement Format

• FASB and the IASB are currently engaged in a

long-term project to restructure the way

information is presented in the financial

statements.

• The focus of this effort is to clearly separate

financial statement items that are related to a

company’s business activities from items that

are related to other activities such as income

taxes or financing.

(continued)

4-744-74(continued)

4-754-75

4-76

Forecasting Future Performance

• Financial statements report the past, but are

used to predict the future.

• Key to a good forecast involves identifying

factors that determine a certain level of revenue

or expense.

• Forecasting starts with a forecast for sales.

• It indicates how fast the company is expected to

grow and represents the general volume of

activity expected in the company.

7. Construct simple forecasts of income

for future periods

4-774-77

4-784-78

4-794-79

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