11

The Income Statement and The Income Statement and the Statement of the Statement of

Stockholders’ EquityStockholders’ EquityChapter 11Chapter 11

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Learning Objective 1Learning Objective 1

Analyze a complex income statement.Analyze a complex income statement.

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Income Statement - Continuing Income Statement - Continuing OperationsOperations

Allied Electronics CorporationIncome Statement

Year Ended December 31, 20x5

Sales revenue $500,000Cost of goods sold –240,000Gross margin $260,000Operating expenses 181,000Operating income $ 79,000

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Operating income $79,000Other gains (losses):Loss on restructuring operations ( 8,000)Gain on sale of machinery 19,000

Income from continuing operationsbefore income tax $90,000

Income tax expense 36,000Income from continuing operations $54,000

Income Statement - Continuing Income Statement - Continuing OperationsOperations

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Discontinued operations: $35,000,less income tax of $14,000 21,000

Income before extraordinary itemsand cumulative effect of changein depreciation method $75,000

Extraordinary flood loss, $20,000,less income tax savings of $8,000 (12,000)

Cumulative effect of change indepreciation method, $10,000,less income tax of $4,000 6,000

Net income $69,000

Income Statement - Special ItemsIncome Statement - Special Items

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Most Analysts and Investors Focus Most Analysts and Investors Focus on Earnings from Continuing on Earnings from Continuing

OperationsOperations Gains (or losses) from discontinued Gains (or losses) from discontinued

operations, extraordinary items, or effects of operations, extraordinary items, or effects of accounting principles changes are non-accounting principles changes are non-recurrentrecurrent

These items are said to be “below the line,” the These items are said to be “below the line,” the line being earnings from continuing operationsline being earnings from continuing operations

Investors tend to factor these out in evaluating Investors tend to factor these out in evaluating the company’s earnings prospectsthe company’s earnings prospects

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Earnings per share of common stock(20,000 shares outstanding):

Income from continuing operations $2.70Income from discontinued operations 1.05Income before extraordinary item and cumulative effect of change in depreciation method $3.75Extraordinary loss (0.60)Cumulative effect of change in depreciation method 0.30

Net income $3.45

Income Statement - Earnings per Income Statement - Earnings per ShareShare

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Continuing OperationsContinuing Operations

The company restructured operations at a loss The company restructured operations at a loss of $8,000.of $8,000.

Report as “Other” item – part of continuing Report as “Other” item – part of continuing operations, but falls outside of main business operations, but falls outside of main business endeavorendeavor

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Items Which Are “Below the Line”Items Which Are “Below the Line”

1.1. Discontinued operationsDiscontinued operations

2.2. Extraordinary itemsExtraordinary items

3.3. Cumulative effect of a change in accounting Cumulative effect of a change in accounting principle principle

4.4. These items must be presented in the above These items must be presented in the above order on the statement of incomeorder on the statement of income

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Discontinued OperationsDiscontinued Operations

Segment – identifiable division of a company Segment – identifiable division of a company is sold at a gain or lossis sold at a gain or loss

Must get completely out of that line of Must get completely out of that line of business to qualify as a segment disposal, and business to qualify as a segment disposal, and therefore “below the line”therefore “below the line”

Otherwise the gain or loss from disposition is Otherwise the gain or loss from disposition is “above the line,”under the caption,“Other “above the line,”under the caption,“Other Gains and Losses”Gains and Losses”

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Extraordinary ItemsExtraordinary Items

To qualify as an extraordinary item, the item must beTo qualify as an extraordinary item, the item must be Unusual Unusual andand infrequent, infrequent, e.g.:e.g.: Losses due to natural disastersLosses due to natural disasters Expropriations (seizure) of propertiesExpropriations (seizure) of properties

If the item is not unusual and infrequent, it must be If the item is not unusual and infrequent, it must be disclosed “above the line,”e.g.:disclosed “above the line,”e.g.: Corporate restructuring chargesCorporate restructuring charges Disposing of a single plant location, but not getting Disposing of a single plant location, but not getting

completely out of that line of business. [There are completely out of that line of business. [There are remaining plants in that line of business.] remaining plants in that line of business.]

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Cumulative Effect of a Change in Cumulative Effect of a Change in Accounting PrincipleAccounting Principle

An example: changing fisrom double-declining-An example: changing fisrom double-declining-balance (DBB) to straight-line depreciationbalance (DBB) to straight-line depreciation

From first-in, first-out (FIFO) to weighted-average From first-in, first-out (FIFO) to weighted-average cost for inventorycost for inventory

Report as the last line item on the income statement, Report as the last line item on the income statement, after extraordinary items, if any in arriving at net after extraordinary items, if any in arriving at net incomeincome

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Earnings per Share

(Net Income – Preferred Dividends)

Earnings per ShareEarnings per Shareof Common Stockof Common Stock

÷

Average Number of Common Shares Outstanding

=

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Earnings per ShareEarnings per Shareof Common Stockof Common Stock

RequiredRequired to be disclosed on the income to be disclosed on the income statement for all major sectionsstatement for all major sections

Earnings per share isEarnings per share is subject to subject to dilution dilution ((reduction), if issue of additional shares is reduction), if issue of additional shares is possible in the future from exercise of:possible in the future from exercise of: Convertible preferred stockConvertible preferred stock Convertible debentures (long-term debt)Convertible debentures (long-term debt) Stock options exercisedStock options exercised

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Comprehensive IncomeComprehensive Income

Change in total stockholders’ equity from all sources Change in total stockholders’ equity from all sources other than from owners of the business (capital other than from owners of the business (capital transactions):transactions): Issuances of stockIssuances of stock payment of dividendspayment of dividends

Includes GAAP net income plus: Includes GAAP net income plus: unrealized gains (losses) on available-for-sale investmentsunrealized gains (losses) on available-for-sale investments foreign-currency translation adjustmentsforeign-currency translation adjustments

Net income $69,000Other comprehensive income: Unrealized gain on investment $ 6,500 Less income tax (40%) 2,600 3,900 Foreign-currency translation adjustment (loss) $(9,000) Less income tax (40%) 3,600 ( 5,400)Comprehensive income $67,500

Statement ofStatement ofComprehensive IncomeComprehensive Income

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

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Learning Objective 2Learning Objective 2

Account for a corporation’s income taxes.Account for a corporation’s income taxes.

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Accounting for CorporateAccounting for CorporateIncome TaxesIncome Taxes

Income tax expense – expense on income Income tax expense – expense on income statementstatement

Income tax payable – liability on balance sheetIncome tax payable – liability on balance sheet

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Accounting for CorporateAccounting for CorporateIncome TaxesIncome Taxes

In general, income tax expense and incometax payable can be computed as follows:

Incometax

payable

Taxableincome (from

the income taxreturn filed

with the IRS)

Incometaxrate

= ×

Incometax

expense

Income beforeincome tax(from theincome

statement)

Incometaxrate

= ×

2020

Suppose for 20x5, Nike, Inc., has pretax accounting Suppose for 20x5, Nike, Inc., has pretax accounting income of $900 million on the income statement, due income of $900 million on the income statement, due to use of straight line depreciation to use of straight line depreciation forfor booksbooks. .

Taxable income is $800 million on the company’s Taxable income is $800 million on the company’s income tax return, due to use of double declining income tax return, due to use of double declining balanced appreciation balanced appreciation for taxesfor taxes. .

This creates a difference between book income and This creates a difference between book income and taxable income (called deferred taxes)taxable income (called deferred taxes)

Assume the tax rate is 40%.Assume the tax rate is 40%.

Accounting for CorporateAccounting for CorporateIncome TaxesIncome Taxes

Accounting for CorporateAccounting for CorporateIncome TaxesIncome Taxes

General Journal

Date Accounts and Explanations PR Debit Credit

Dec 31 Income Tax Expense ($900 x .40) 360 Income Tax Payable ($800 x .40) 320 Deferred Tax Liability 40Recorded income tax for the year

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

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Income statementIncome before income tax $900Income tax expense 360Net income $540

Balance sheetCurrent Liabilities: Income tax payable $320Long-term liabilities: Deferred tax liability 40*Total $360

*Assumes beginning tax liability was zero.

Accounting for CorporateAccounting for CorporateIncome TaxesIncome Taxes

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CCorrections to the beginning balance of orrections to the beginning balance of Retained Earnings for errors of a previous Retained Earnings for errors of a previous accounting periodaccounting period

Prior-Period AdjustmentsPrior-Period Adjustments

CNN CorporationStatement of Retained EarningsYear Ended December 31, 2005

Retained Earnings, Dec. 31, 2004 (original) $390,000Prior-period adjustment – debit to correct error in recording income tax expense of 2004 ( 10,000)Retained earnings, Dec. 31, 2004, adjusted $380,000Net income for 2005 114,000Total $494,000Deduct: Dividends for 2005 ( 41,000)Retained earnings balance, Dec. 31, 2005 $453,000

Reporting a Prior-Period Reporting a Prior-Period AdjustmentAdjustment

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

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Restrictions on Retained Restrictions on Retained EarningsEarnings

Dividends and purchases of treasury stock constitute Dividends and purchases of treasury stock constitute payments by the corporation to its stockholderspayments by the corporation to its stockholders

Creditors may restrict a corporation’s dividend Creditors may restrict a corporation’s dividend payments and treasury stock purchase activity:payments and treasury stock purchase activity: legally, creditors have priority to corporate assets if there legally, creditors have priority to corporate assets if there

is a corporate dissolutionis a corporate dissolution Dividend and treasury stock purchases effectively Dividend and treasury stock purchases effectively

circumvent creditor rights, conveying assets to circumvent creditor rights, conveying assets to stockholders that would otherwise be available to creditorsstockholders that would otherwise be available to creditors

Companies must report any retained earnings Companies must report any retained earnings restrictions in notes to the financial statementsrestrictions in notes to the financial statements

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Learning Objective 3Learning Objective 3

Analyze a statement of stockholders’ equity.Analyze a statement of stockholders’ equity.

Analyzing the Statement of Analyzing the Statement of Stockholder’s EquityStockholder’s Equity

Common Stock, $1

par

Additional Paid-in Capital

Retained Earnings

Treasury Stock

Balance, Dec. 31, 20x4 $80,000 $160,000 $130,000 ($25,000)Issuance of stock 20,000 65,000 Net income 69,000 Cash dividends (21,000) Stock dividend – 8% 8,000 26,000 (34,000) Purchase of treasury stock (9,000) Sale of treasury stock 7,000 4,000 Unrealized gain on investments Foreign-currency translation adjustment

Balance, Dec. 31, 20x5 108,000$ 258,000$ 144,000$ (30,000)$

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

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Analyzing the Statement of Analyzing the Statement of Stockholder’s EquityStockholder’s Equity

Unrealized Gain (Loss) on

Investments

Foreign-Currency Translation Adjustment

Balance, Dec. 31, 20x4 $6,000 ($10,000) $341,000Issuance of stock 85,000 Net income 69,000 Cash dividends (21,000) Stock dividend – 8% -0-Purchase of treasury stock (9,000) Sale of treasury stock 11,000 Unrealized gain on investments 1,000 1,000 Foreign-currency translation adjustment 3,000 3,000 Balance, Dec. 31, 20x5 $7,000 ($7,000) $480,000

Accumulated Other Comprehensive Income

Total Stockholders’

Equity

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Learning Objective 4Learning Objective 4

Understand managers’ and auditors’ Understand managers’ and auditors’ responsibilities for the financial statements.responsibilities for the financial statements.

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Responsibility for theResponsibility for theFinancial StatementsFinancial Statements

Management of public companiesManagement of public companies Must issue Must issue statements of responsibility for the financial statements of responsibility for the financial

statements and entity systems of internal control statements and entity systems of internal control in annual in annual report filings to the SECreport filings to the SEC

These statements of responsibility declare:These statements of responsibility declare: Responsibility for the financial statements and states that the Responsibility for the financial statements and states that the

financial statements conform with GAAP (generally accepted financial statements conform with GAAP (generally accepted accounting principles)accounting principles)

That internal controls are suitably designed/implemented and are That internal controls are suitably designed/implemented and are operating effectivelyoperating effectively

Can go to jail for up to 25 years and be personally fined up Can go to jail for up to 25 years and be personally fined up to $5 million for knowingly misrepresenting these to $5 million for knowingly misrepresenting these statements of responsibility, under the provisions of the statements of responsibility, under the provisions of the Sarbanes-Oxley ActSarbanes-Oxley Act

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Auditor ReportAuditor Report

Typically contains three paragraphs:Typically contains three paragraphs: Introductory paragraph identifies the audited Introductory paragraph identifies the audited

financial statementsfinancial statements Scope paragraph generally describes how the audit Scope paragraph generally describes how the audit

was performedwas performed Opinion paragraph states the Opinion paragraph states the auditor’s opinion auditor’s opinion thatthat

the financial statements conform with GAAP in all the financial statements conform with GAAP in all material respectsand people can rely on them for material respectsand people can rely on them for decision makingdecision making

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Auditor ReportAuditor Report Unqualified (Clean) opinion on the financial statementsUnqualified (Clean) opinion on the financial statements Qualified opinion: the financial statements present fairly in all Qualified opinion: the financial statements present fairly in all

material respects, except for a material respects, except for a materialmaterial:: GAAP departureGAAP departure Scope restriction, the effects of which could be Scope restriction, the effects of which could be materialmaterial to the financial to the financial

statementsstatements Adverse: there is an Adverse: there is an extremely materialextremely material GAAP departure GAAP departure Disclaimer caused by:Disclaimer caused by:

A scope restriction, the effects of which could be A scope restriction, the effects of which could be extremelyextremely materialmaterial to to the financial statements, orthe financial statements, or

The auditor lacks independenceThe auditor lacks independence