The Income statement and statement of cash flows

1
The Income statement and statement of cash flows

• Chapter 4

2
Income from Continuing Operations
Expenses Outflows of resources incurred in
generating revenues.
Revenues Inflows of resources resulting from
providing goods or services to customers.
Gains and Losses Increases or decreases in equity
from peripheral or incidental transactions of an
entity.
Income Tax Expense Because of its importance and
size, income tax expense is a separate item.
3
Operating Income Versus Nonoperating Income
Operating Income
Nonoperating Income
Includes gains and losses and revenues and
expenses related to peripheral or incidental
activities of the company
Includes revenues and expenses directly related
to the principal revenue-generating activities of
the company
4
Income Statement (Single-Step)
5
Income Statement (Multiple-Step)
6
Earnings Quality
Earnings quality refers to the ability of
reported earnings to predict a companys future
earnings.
Transitory Earnings versus Permanent Earnings
7
Manipulating Income and Income Smoothing
Most managers prefer to report earnings that
follow a smooth, regular, upward path.1

• Two ways to manipulate income
• Income shifting
• Income statement classification

1 Bethany McLean, Hocus-Pocus How IBM Grew 27
a Year, Fortune, June 26, 2000, p. 168.
8
Operating Income and Earnings Quality
Restructuring Costs
Costs associated with shutdown or relocation of
facilities or downsizing of operations are
recognized in the period incurred.
9
Nonoperating Income and Earnings Quality
Gains and losses from the sale of operational
assets and investments often can significantly
inflate or deflate current earnings.
How should those gains be interpreted in terms of
their relationship to future earnings? Are they
transitory or permanent?
ExampleAs 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.
10
Pro Forma Earnings
Companies often voluntarily provide a pro forma
earnings number when they announce annual or
quarterly earnings. Pro forma earnings are
managements assessment of permanent earnings.
The Sarbanes-Oxley Act Section 401 requires a
reconciliation between pro forma earnings and
earnings determined according to GAAP.
11
Separately Reported Items
Reported separately, net of taxes
Discontinued operations
Extraordinary items
A third item, the cumulative effect of a change
in accounting principle, was eliminated from
separate reporting by a new accounting standard
in 2005.
12
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.
13
Discontinued Operations

• A discontinued operation is the sale or disposal
  of a component of an entity.
• A component comprises operations and cash flows
  that can be clearly distinguished, operationally
  and for financial reporting purposes, from the
  rest of the entity.
• A component could include
• Reportable segments
• Operating segments
• Reporting units
• Subsidiaries
• Asset groups

14
Discontinued Operations
Report results of operations separately if two
conditions are met
The operations and cash flows of the component
have been (or will be) eliminated from the
ongoing operations.
The entity will not have any significant
continuing involvement in the operations of the
component after the disposal transaction.
15
Discontinued Operations
16
Discontinued Operations Example
During the year, Apex Co. sold an unprofitable
component of the company. The component had a
net loss from operations during the period of
150,000 and its assets sold at a loss of
100,000. Apex reported income from continuing
operations of 128,387. All items are taxed at
30. How will this appear in the income
statement?
17
Discontinued Operations Example
Computation of Loss from Discontinued Operations
(Net of Tax Effect)
18
Discontinued Operations Example
Income Statement Presentation
19
Extraordinary Items

• Material events or transactions
• Unusual in nature
• Infrequent in occurrence
• Reported net of related taxes

20
Extraordinary Items Example
During the year, Apex Co. experienced a loss of
75,000 due to an earthquake at one of its
manufacturing plants in Nashville. This was
considered an extraordinary item. The company
reported income before extraordinary item of
128,387. All gains and losses are subject to a
30 tax rate. How would this item appear in the
income statement?
21
Extraordinary Items Example
Computation of Loss from Extraordinary Item (Net
of Tax Effect)
22
Unusual or Infrequent Items
Items that are material and are either unusual or
infrequentbut not bothare included as a
separate item in continuing operations.
23
Accounting Changes
24
Change in Accounting Principle

• Occurs when changing from one GAAP method to
  another GAAP method
• For example, a change from LIFO to FIFO
• Most voluntary changes in accounting principles
  are accounted for retrospectively by revising
  prior years financial statements.
• Changes in depreciation, amortization, or
  depletion methods are accounted for the same way
  as a change in accounting estimate.

25
Change in Accounting Estimate
Revision of a previous accounting estimate
Use new estimate in current and future periods
Includes treatment for changes in depreciation,
amortization, and depletion methods
26
Change in Accounting Estimate Example
On January 1, 2003, we purchased equipment
costing 30,000, with a useful life of 10 years
and no salvage value. During 2006, we determine
that the remaining useful is 5 years (8-year
total life). We use straight-line
depreciation. Compute the revised depreciation
expense for 2006.
27
Change in Accounting Estimate Example
Record depreciation expense of 4,200 for 2006
and subsequent years.
28
Change in Reporting Entity
If two entities combine, a single set of
consolidated financial statements is generally
required.
29
Change in Reporting Entity
A change in reporting entity is reported by
restating all previous periods financial
statements presented for comparative purposes as
if the new reporting entity existed in those
periods.
30
Correction of Accounting Errors

• Correction of errors from a previous period
• Appear in the Statement of Retained Earnings as
  an adjustment to beginning retained earnings
  (show the adjustment net of income taxes)
• Previous years financial statements that are
  incorrect are retrospectively restated to reflect
  the correction.

31
Prior Period Adjustments Example
While reviewing the depreciation entries for
2002-2007, the controller found that in 2006
depreciation expense was incorrectly debited for
150,000 when in fact it should have been debited
125,000. (Ignore income taxes.) Prepare the
necessary journal entry in 2007 to correct this
prior period error.
32
Prior Period Adjustments Example
33
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.
34
Earnings Per Share Disclosure

• Report EPS data separately for
• Income from Continuing Operations
• Separately Reported Items
• Discontinued Operations
• Extraordinary Items
• Net Income

35
Comprehensive Income
An expanded version of income that includes four
types of gains and losses that traditionally have
not been included in income statements.
36
Other Comprehensive Income
Statement of Financial Accounting Standards No.
130 Comprehensive income includes traditional net
income and changes in equity from nonowner
transactions.

• Changes in the market value of securities
  available for sale (described in Chapter 12).
• Reporting a pension liability sometimes requires
  a reduction in shareholders equity (described in
  Chapter 17).
• 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 (described in Chapter 14).
• Gains or losses from changes in foreign currency
  exchange rates (discussed elsewhere in your
  accounting curriculum).

37
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.
38
The Statement of Cash Flows

• Provides relevant information about a companys
  cash receipts and cash disbursements.
• Helps investors and creditors to assess
• future net cash flows
• liquidity
• long-term solvency.
• Required for each income statement period
  reported.

39
Statement of Cash Flows Operating Activities
Cash Flows from Operating Activities
40
Investing Activities

• Inflows from
• Sale of long-term assets used in the business.
• Sale of investment securities (stocks and bonds).
• Collection of nontrade receivables.

Cash Flows from Investing Activities
41
Financing Activities

• Inflows from
• Sale of shares to owners.
• Borrowing from creditors through notes, loans,
  mortgages, and bonds.

Cash Flows from Financing Activities

• Outflows to
• Owners in the form of dividends or other
  distributions.
• Owners for the reacquisition of shares previously
  sold.
• Creditors as repayment of the principal amounts
  of debt.

42
Noncash Investing and Financing Activities
Significant investing and financing transactions
not involving cash also are reported.
Acquisition of equipment (an investing activity)
by issuing a long-term note payable (a financing
activity).
43
Statement of Cash Flows Direct and Indirect
Methods of Reporting
Two Formats for Reporting Operating Activities
44
Direct and Indirect Methods
45
End of Chapter 4