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Chapter 13:Chapter 13:

Income StatementIncome Statement

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Chapter 13: Income StatementChapter 13: Income StatementI. Financial statement relationships.II. Income statement categories:

1. operating revenues and expenses2. other revenues and expenses3. discontinued operations4. extraordinary items

III. Earnings per share IV. Economic consequences associated with

reporting net income.

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I. Relationships Among the I. Relationships Among the Financial Statements Financial Statements

Statement ofCash Flows

BeginningBalance Sheet

IncomeStatement

Statement ofRetainedEarnings

(or Statement of SE)

EndingBalance Sheet

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II. Elements of the Income StatementII. Elements of the Income StatementComprehensive income - changes in net

assets from all non-owner sources; is broken into two categories:– net income: consisting of revenues,

expenses, gains and losses (next slide)– other comprehensive income:

consisting of equity adjustments not reflected in the income statement. Examples include:unrealized gains and losses from

revaluation of AFS investments.cumulative translation adjustment for

foreign subsidiaries.

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II. Elements of the Income StatementII. Elements of the Income StatementRevenues - increases in net assets for

activities that constitute a company’s ongoing central operations.

Expenses - decreases in net assets for activities that constitute a company’s ongoing central operations.

Gains - increases in net assets for activities that constitute a company’s peripheral activities.

Losses - decreases in net assets for activities that constitute a company’s peripheral activities.

Note that account titles do not always match with activity (ex: interest revenue and interest expense are peripheral activity).

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II. Format of the I/SII. Format of the I/SSee Page 565 for example of categories: Sales- COGS= Gross profit- Operating expenses= Income from operations+ Other revenues and gains- Other expenses and losses= Income from continuing operations (IFCO)+/-Discontinued operations+/-Extraordinary items= Net income(Note: text also includes “Change in Accounting Principles” but the FASB statement to eliminate this category is expected to be issued in mid 2005.)

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II. Format of the I/SII. Format of the I/S First, note the subtotals (=)

– Gross profit is presented when a company uses a multi-step income statement; more relevant for companies that are primarily retail or manufacturing (less relevant for service industries).

– Income from operations indicates income from primary, on-going activity (usual and frequent).

– Income from continuing operations (IFCO) also includes peripheral activity like interest income, as well as potentially nonrecurring activity like restructuring charges (unusual or infrequent).

– Net income also includes “special” items that are presented separately because they are significant activities that are usually nonrecurring.

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II. Format of the I/SII. Format of the I/S Now, more information on the “special” items below

IFCO:– discontinued operations– extraordinary items

Note that each of these items is presented “net of tax.” This is necessary because income tax expense has already been calculated on IFCO. Therefore, each level below IFCO must present the tax effect for that component.

This is called “intraperiod” tax allocation - allocation of income tax expense to different parts of the income statement.

A “partial” income statement is presented on the next slide (and assumes a 25% tax rate).

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II. Partial Income Statement- II. Partial Income Statement- Sample Company Sample Company

(assuming a 25% tax rate)(assuming a 25% tax rate)

Income from continuing operations $120Income tax expense (30)Income from continuing operations - net of tax 90Discontinued operations

Income from operations of discontinued segment(less tax effect of $25) 75

Loss on disposal of discontinued segment(less tax effect of $10) (30)

Extraordinary itemLoss from flood damage

(less tax effect of $9) (27)

Net income $108

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II. Calculations - Sample CompanyII. Calculations - Sample Company

Note that “net of tax” can either be a gain/income offset by income tax expense, or a loss offset by an income tax reduction. In either case, the amount recognized is net, after the tax effect is subtracted out.

In Sample Company, the calculations are based on a 25% income tax expense rate:

Note that the pretax amounts = the net amount + taxDiscontinued operations

Pretax income of $100 x 25% = $25 expense Pretax loss of $40 x 25% = $10 expense reduction

Extraordinary (pretax) loss of $36 x 25% = $9 expense reduction

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II. Format - Discontinued OperationsII. Format - Discontinued Operations Discontinued operations (DO) relate to the disposal of

a segment of a company. Because the disposal means that the segment activity will be discontinued, separate disclosures are required so that investors could distinguish between ongoing activity and nonrecurring activity.

A segment is defined as an entire line of business or a separately identifiable segment. For example, General Motors would need to discontinue Chevrolet (not just a manufacturing plant).

Financial statement presentation includes any operating income or loss to the measurement date (the date the board of directors declares intention to dispose of the segment), as well as any gain or loss on the disposal of the assets.

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II. Problems with Discontinued Op.II. Problems with Discontinued Op.

Does not require a sales contract to reclassify to discontinued operations.

IFCO can be manipulated with the declaration (and reclassification) of the discontinued segment.

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II. Format - Extraordinary ItemsII. Format - Extraordinary Items

Extraordinary items are defined as those activities that are material in amount, unusual in nature, and infrequent in occurrence.

To determine, consider the natural, political, and economic environment of the firm.

Examples of EI include natural disasters, nationalization or expropriation of assets by a foreign government, and one-time major economic transactions.

If unusual or infrequent, but not both, report in “other gains/losses”, as part of IFCO. Examples include material write-down of receivables, and loss from employee strike.

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I/S Classification - Class ProblemI/S Classification - Class Problem1.Loss in Florida from hurricane:

2.Loss from sale of a segment:

3.Loss from terrorist activity:

4.Material write-off of accounts receivable:

5.Normal write-off of accounts receivable:

6.Loss from flood (in a 500-year flood plain):

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II. I/S Format - Other IssuesII. I/S Format - Other IssuesConsistency requires the use of the same

accounting method from year to year.However, a company may choose to

change to an alternative accounting method (ex: DDB to SL or FIFO to average).

Also, a company may be required to change to a new accounting technique by the issue of a new accounting standard.

The APB required companies to show the cumulative effect for prior years’ income on the current income statement in a special category called “change in accounting principle.”

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II. I/S Format - Other IssuesII. I/S Format - Other Issues This special category allowed investors to

analyze IFCO for the current year separately from the effect of the cumulative change.

Problem: This “cumulative” calculation was reported as part of current net income, even though it relates to prior years’ net income.

Solution: FASB will recently (in mid 2005) eliminate this category from the income statement. Then all changes in principle will receive either a retroactive restatement (like errors of a prior period) or a prospective treatment (like changes in estimate).

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III. Earnings Per Share (EPS)III. Earnings Per Share (EPS) SFAS 128 simplified the presentation of earnings

per share to two components:– basic EPS– diluted EPS

Calculation of Basic EPS = Net Income - preferred dividends

Average common shares outstanding Concept: To indicate how much each common

shareholder “owns” with respect to earnings. Preferred dividends are deducted - if declared or if

cumulative - because they are “owned” by to preferred shareholders.

This is a calculation of “what is” - the numerator and denominator use actual shares outstanding and actual net income for the year.

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III. Earnings Per Share (EPS)III. Earnings Per Share (EPS) Diluted earnings per share examines all the

potentially dilutive securities that a company has issued, like convertible preferred stock, convertible bonds, and employee stock options. Although these securities have not been converted at year end, the calculation shows the effect that the shares could have on EPS.

Calculation of Diluted EPS = Net Income - P.D. + adjustment for dilutive shares Avg. CS outstanding + adjustment for dilutive shares

Concept: To indicate how much each common shareholder would “own” with respect to earnings IF all dilutive securities had been exercised at the beginning of the year.

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III. Earnings Per Share (EPS)III. Earnings Per Share (EPS) Diluted EPS is a “what if” calculation - the numerator

and denominator are adjusted for potential effects of dilutive securities as of the securities had been converted to common stock at the beginning of the current year:– convertible PS:

eliminate preferred dividend (would not exist if converted) increase shares outstanding (would be larger if converted)

– convertible bonds: eliminate interest expense (would not exist if converted) increase shares outstanding (would be larger if converted)

– stock options: no numerator effect (generally speaking) increase shares outstanding (note that it is not a 1 for 1

conversion). If any of these potentially dilutive securities exist, the

company is said to have a complex capital structure.

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III. Earnings Per Share (EPS)III. Earnings Per Share (EPS)Class problem:Bush Company reported net income of $30,000 in 2005. The company had 60,000 shares of common stock outstanding for all of 2005. Bush also had 5,000 shares of convertible preferred stock outstanding for all of 2000. During 2005, the company declared a $4,000 cash dividend to preferred shareholders. Each share of preferred stock is convertible to 4 shares of common stock.1.Calculate basic EPS:

$30,000 - 4,000 = $0.43 per share 60,000 (Note that the convertibility component is ignored for basic EPS.)

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III. Earnings Per Share (EPS)III. Earnings Per Share (EPS)

2.Calculate diluted EPS: $30,000 - 0 _ = $0.38 per share

60,000 + (5,000 x 4)

Note that the convertibility component is assumed to have been exercised for diluted EPS. If the PS was converted to CS at the beginning of the year, there would have been NO preferred dividend, and there would have been 20,000 additional shares of common stock outstanding all year.

The effects for convertible bonds and employee stock options are similar for diluted EPS.

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III. EPS DisclosureIII. EPS Disclosure Separate EPS disclosure for:

– Net income from continuing operations (after tax)

– Disposals of business segments– Extraordinary items

Calculation– Separate dollar amount (from above

categories) divided by number of common shares outstanding

If diluted EPS exists, the company should also calculate diluted EPS for each level of presentation.

If diluted EPS is antidilutive (the calculation is actually higher than basic EPS), the company does not have to present diluted EPS.

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III. EPS Disclosure - Sample Co.III. EPS Disclosure - Sample Co.(Based on 100,000 shares outstanding.)(Based on 100,000 shares outstanding.)

Basic Earnings Per Share:Income from continuing operations $0.90Discontinued operations

Income from operations of segment 0.75Loss on disposal

(0.30)Extraordinary loss (0.27)Net income $1.08$1.08

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III.III. Problems with EPSProblems with EPSThe numerator can be manipulated by a

number of earning management techniques.The denominator can be manipulated by stock

buybacks (treasury stock).The “what-if” presentation of diluted EPS is a

fictitious number - it can never actually happen. The potentially dilutive securities have not been converted at year end, and they can never have claims to the current year’s income. The only benefit of diluted EPS is that it can indicate the magnitude of the maximum potential dilution for the future.

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IV. Economic Consequences of IV. Economic Consequences of Reporting Net IncomeReporting Net Income

Investors focus heavily on income and related indices like earnings per share and the P/E (price per share to earnings per share) ratio.

Recent announcements (noting that the reported EPS was off the estimate by as little as a penny) have caused the market price of reporting companies to drop significantly.

Because of investor focus, and because of compensation bonuses, managers continue to focus heavily on the bottom line, sometimes with dire effects.

Expanded financial statement disclosure, and increased awareness by investors, may stem this earnings fixation.