b a c kn e x t h o m e thomas h. beechy schulich school of business, york university joan e. d....

b a c k n e x th o m e

Thomas H. BeechySchulich School of Business,

York University

Joan E. D. ConrodFaculty of Management,

Dalhousie University

PowerPoint slides by: Bruce W. MacLean, Bruce W. MacLean,

Faculty of Management, Faculty of Management,

Dalhousie UniversityDalhousie University

Copyright 1998 McGraw-Hill Ryerson Limited, Canada

Intermediate Accounting


Thomas H. BeechySchulich School of Business,

York University

Joan E. D. ConrodFaculty of Management,

Dalhousie University

PowerPoint slides by: Bruce W. MacLean, Bruce W. MacLean,

Faculty of Management, Faculty of Management,

Dalhousie UniversityDalhousie University


The Income Statement and the Retained Earnings Statement

Chapter 3


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INTRODUCTION

Current profit performance The income statement is the primary source of information.

Predicting future income and cash flows. Financial statement readers use this and other information to estimate the amount, timing, and uncertainty

Providing feedback: How good were predictions of prior years’ earnings?

Performance evaluation. Investors look at the return and risk of their investment.

Comparing Investments

7%

9%

11%

13%

5% 6% 7% 8% 9%

Risk

Ret

urn

IBM Nortel ABC


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NATURE OF INCOME

Change in Retained Earnings Economic Income versus

Accounting Income Inclusiveness of the

Income Statement Income as a

Predictive Tool


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Change in Retained Earnings

When there is no new investment or disinvestment by owners the change in owners' equity from the beginning to the end of the period equals net income.

Balance Sheet31 December 20x1

Income StatementYear ended

31 December 20x2

Balance Sheet31 December 20x2

Liabilities Liabilities

Assets Assets

Owners’ Revenues Owners’ equity + Expenses equity

= Net Income =

The income statement links a company's beginning and ending balance sheets for a given accounting period.


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Economic Income versus Accounting Income

The term income means different things to different people. Economist: An economist defines a change in wealth, whether

realized or not, as income. The wealth increase (Value>Cost) is called economic income, and it is based on an events approach rather than on completed transactions.

Accountant: Using the historical cost measurement principle, an accountant usually would not recognize such an increase in wealth as income. Only if the land is sold at fair value to another party in an arm’s‑length transaction would the accountant recognize the increase in wealth as income. This is accounting income, based on the transactions approach.

Example: Suppose that a company owns a parcel of land for which it paid $10,000 several years ago. A new highway has just been built next to the property, and several individuals have offered to pay $125,000 to $150,000 for the land. The firm has not yet agreed to sell.


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General problems with the transactions approach to reporting income

Not all relevant information is captured by transactions – For example, the relevant market value of the land in the above example is

excluded from recognition in the financial statements, but is of considerable interest to a bank that uses the land as collateral for a loan.

Management makes choices about the accounting policies and accounting estimates

– Accounting policies determine which transactions are recorded and how their impacts are measured. Rules for estimates are flexible.

Management can use transactions to manipulate results

– Management can enter into transactions (or avoid transactions) with the primary purpose of affecting the reported results. .


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Income Statement Concepts

4. Revenues are increases ineconomic resources, either byway of (a) inflows orenhancements of assets or (b)reductions of liabilities,resulting from the ordinaryactivities of an entity,normally from the sale ofgoods, the rendering ofservices, or the use by othersof entity resources yieldingrent, interest, royalties, ordividends

4. An essential characteristic of arevenue transactions is that itarises from the company’sordinary earning activities, andnot from (a) capital transactions,(b) the settlement of monetaryliabilities, or (c) the sale ofcapital assets or investmentassets

5. Expenses are decreasesin economic resources,either by way of (a)outflows or reductions ofassets or (b) incurrencesof liabilities, resultingfrom the ordinaryrevenue-earning activitiesof an entity.

5. The essential characteristic ofan expense is that it must beincurred in conjunction with thecompany’s revenue generatingprocess. Expenditures that do notqualify as expenses are treatedeither as assets (future economicbenefit to be derived), as losses(no economic benefit), or asdistributions to owners.

6. Gains are increases in net assetsfrom peripheral or incidentaltransactions and events affectingan entity and from all othertransactions, events, andcircumstances affecting an entitythat are given accountingrecognition except those that resultfrom revenues or equitycontributions.

6. The transaction must notbe one that meets thecharacteristics of (a) arevenue-producingtransaction or (b) a capitaltransaction (e.g., capitalinfusion by the owners).

7. Losses are decreases in equityfrom peripheral or incidentaltransactions and events affectingan entity and from all othertransactions, events, andcircumstances affecting an entitythat are given accountingrecognition except those thatresult from expenses ordistributions of equity.

7. The transaction mustnot be one that meetsthe characteristics of

(a) an expensetransaction or

(b) a capital transaction(e.g., dividends orother distributions toowners).


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Inclusiveness of the Income Statement

Which items affecting shareholders’ equity should be included in the computation of net income and reported in the income statement?

CurrentOperatingPerformance.

Items that are part of the ordinary recurring operations of the firm should beincluded in earnings. Other items, for example, gains and losses that relate toprior periods or to unusual or non-recurring activities are recorded as directadjustments to retained earnings. Net income” should have maximum power forpredicting operating income.

All-InclusiveApproach.

All transactions affecting the net increase or decrease in equity during theperiod are included in the determination of net income, except contributions byor distributions to owners. Decreases the probability that they will beoverlooked in a review of the operating results for a period of years. Reduce thedangers of possible manipulation of the annual earnings figure. Assess fully theimportance of each item and its effect on operating results and cash flows.

CurrentPractice.

Accounting standards in Canada generally reflect an approach that is closer tothe all-inclusive approach. Virtually all items affecting equity (other thaninvestment by or distributions to owners) are included in net income; the AcSBhas largely eliminated the possibility of charging or crediting items directly toretained earnings except for corrections of errors and for restatements due tochanges in accounting policies. Separately identify and disclose the variousspecial non-operating items separately on the face of the income statement.


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Income as a Predictive Tool

Earnings trends are important analytical tools used by investment analysts and investors in forecasting a company's future earnings.

Forecasts of future earnings are one factor often used in making investment decisions.

Past trends and performance do not guarantee continuation of such trends and performance in the future, but they are often useful in prediction.

The Royal Bank of Canada reported earnings of $1,169 in 1994and $1,262 in 1995 (amounts in millions). The increase in 1995over 1996 was about 8%.

Based on this data, and your understanding that the bankoperated in a stable environment in 1996, what estimate couldyou provide for 1996 earnings?

Another 8% increase would translate into a prediction of$1,363 ($1,262 1.08%), not too far off the bank’s reported1996 earnings of $1,430, which was an increase of about 13%over 1995.

If you predict another 13% increase for 1997, you’d get anestimate of about $1,616; actual 1997 net income was $1,679.Well, prediction is not really that easy.

The Royal Bank of Canada reported earnings of $1,169 in 1994and $1,262 in 1995 (amounts in millions). The increase in 1995over 1996 was about 8%.

Based on this data, and your understanding that the bankoperated in a stable environment in 1996, what estimate couldyou provide for 1996 earnings?

Another 8% increase would translate into a prediction of$1,363 ($1,262 1.08%), not too far off the bank’s reported1996 earnings of $1,430, which was an increase of about 13%over 1995.

If you predict another 13% increase for 1997, you’d get anestimate of about $1,616; actual 1997 net income was $1,679.Well, prediction is not really that easy.


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Exhibit 3-1 Consolidated Statement of IncomeEXHIBIT 3-1

Canadian National Railway CompanyConsolidated Statement of Income

Year ended December 31(in millions of Canadian dollars)

1997 1996 1995(restated) (restated)

Revenues 4,352 3,995 3,954Operating expenses 3,545 3,766 4,967Operating income (loss) 807 229 (1,013)

Interest expense (118) (114) (198)Other income 57 27 100

Income (loss) from continuing operationsbefore income taxes 746 142 (1,111)

Income tax (expense) recovery from continuing operations (325) 694 19Income (loss) from continuing operations 421 836 (1,092)

Discontinued operations (net of applicable income taxes) (18) 14 7Net income (loss) $ 402 $ 805 $(1,085)

Earnings per share Note 16References to other disclosure notes have been omitted.

RevenuesIndustrial products $ 893 $ 851 $ 838Forest products 824 787 771Grain and grain products 692 564 600Coal, sulphur, and fertilizers 635 618 601Intermodal 776 677 635Automotive 435 389 399Other items 97 109 110

Operating ExpensesLabour and fringe benefits 1,431 1,381 1,477Material 316 297 318Fuel 335 314 277Depreciation and amortization 200 194 231Operating taxes 186 171 192Equipment rentals 219 216 194Net car hire 116 108 117Purchased services 363 348 354Casualty and insurance 103 85 52Other 273 271 302

Special charges – 381 1,453

• CN reports a loss of $(1,085) in 1995, net income of $805 in 1996

and net income of $402 in 1997. • It’s hard to see a trend based on bottom-line net income! • What will 1998 hold for CN? • To answer that question, one would certainly seek forecasts of economic activity in CN’s major areas of operation – transportation, industrial products, forest products, mining, etc. • These sectors represent major areas of the Canadian economy, and there are lots of sources to consult.

EXHIBIT 3-1

Canadian National Railway CompanyConsolidated Statement of Income

Year ended December 31(in millions of Canadian dollars)

1997 1996 1995(restated) (restated)

Revenues 4,352 3,995 3,954Operating expenses 3,545 3,766 4,967Operating income (loss) 807 229 (1,013)

Interest expense (118) (114) (198)Other income 57 27 100

Income (loss) from continuing operationsbefore income taxes 746 142 (1,111)

Income tax (expense) recovery from continuing operations (325) 694 19Income (loss) from continuing operations 421 836 (1,092)

Discontinued operations (net of applicable income taxes) (18) 14 7Net income (loss) $ 402 $ 805 $(1,085)

Earnings per share Note 16References to other disclosure notes have been omitted.

Going a bit further up CN’s income statement, one might notice something called “special charges” which, at $1,453, was fairly instrumental in the 1995 reported loss. In 1996, there was another special charge of $381, but there is no such charge in 1997. Reference to the notes (not reproduced here) indicates that there were a few things in this category, but the biggest item in 1995 was the write down of one of CN’s capital assets, rail properties, by $1,300. Rail properties were written down because their value was impaired: their future cash flow was deemed insufficient to recover their capital cost. In 1996, the special charge was made for estimated workforce reduction costs expected to be incurred in 1997 (but to be paid out over the next seven years). A little detective work has paid off.

Going a bit further up CN’s income statement, one might notice something called “special charges” which, at $1,453, was fairly instrumental in the 1995 reported loss. In 1996, there was another special charge of $381, but there is no such charge in 1997. Reference to the notes (not reproduced here) indicates that there were a few things in this category, but the biggest item in 1995 was the write down of one of CN’s capital assets, rail properties, by $1,300. Rail properties were written down because their value was impaired: their future cash flow was deemed insufficient to recover their capital cost. In 1996, the special charge was made for estimated workforce reduction costs expected to be incurred in 1997 (but to be paid out over the next seven years). A little detective work has paid off.

One anomoly that might catch your eye is the fact that 1996 shows a huge tax recovery of $694, even though operations were modestly profitable and would normally be expected to result in an income tax expense. The reason can be traced (in the notes) to a change in accounting policy; CN chose to apply the AcSB’s revised income tax accounting rules well in advance of their mandatory effective date of 2000. This accounting change permitted the company to recognize, in 1996, a one-time gain of $768 as the probable future tax benefits from past operating losses; there is no cash flow associated with this gain, at least not in 1996. If the gain had not been recognized, income tax expense would have been $74.

One anomoly that might catch your eye is the fact that 1996 shows a huge tax recovery of $694, even though operations were modestly profitable and would normally be expected to result in an income tax expense. The reason can be traced (in the notes) to a change in accounting policy; CN chose to apply the AcSB’s revised income tax accounting rules well in advance of their mandatory effective date of 2000. This accounting change permitted the company to recognize, in 1996, a one-time gain of $768 as the probable future tax benefits from past operating losses; there is no cash flow associated with this gain, at least not in 1996. If the gain had not been recognized, income tax expense would have been $74.

Will there be more special charges in future years? Or was these one-time events? Information from the company, and from industry experts, will help in this assessment. But, taking out the non-recurring items noted above, earnings from continuing operations would be as follows:

1997 1996 1995Income from continuing operations, as reported 421 836 (1,092)Subtract special, nonrecurring, income tax gain (768)Add back special, nonrecurring, charges 381 1,453

Restated earnings from continuing operations 421 449 361


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Choice in Format Issues

Title Fiscal Year End Reporting Period

Length and Composition Reporting Currency Rounding Language Comparative data

Detail Display Single Step Format Multiple Step Format

– Operations Section– Non-Operations Section– Other possible sections– Income tax expenses


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Exhibit 3-2

EXHIBIT 3-3Cott Corporation

Consolidated Statement of Earningsin thousands of dollars, except per share amounts

25-Jan-97 27-Jan-96 28-Jan-95Sales $1,351,567 $1,277,393 $1,061,754Cost of Goods Sold 1,135,543 1,128,596 912,143Gross Profit 216,024 148,797 149,611Selling, General and Administrative Expenses 102,426 103,159 70,939Earnings before the Undernoted 113,598 45,638 78,672Amortization of capital assets 25,304 17,566 10,755Amortization of goodwill, licenses and trademarks 2,745 2,044 2,540Amortization of other assets 8,834 6,208 4,196Interest on long-term debt 25,357 17,578 4.489Other interest 1,952 2,335 2,110Interest income and other expense -2,944 -459 -1,821Restructuring costs 12,076 37,156 –Gain on reduction of investments in joint ventures -2,260 – –Settlement of class action lawsuit 1,915 – –

72,979 82,428 22,269Earnings (loss) Before Income Tax 40,619 -36,790 56,403Income TaxesCurrent 5,554 -2,487 20,236Deferred 6,367 -7,539 73

11,921 -10,026 20,309Earnings (loss) Before Undernoted 28,698 -26,764 36,094Minority Interest -613 516 -1,538Equity in Net Earnings of Long-term Investment 1,388 1,261 1,330Earnings (loss) from Continuing Operations 29,476 -24,987 35,886Earnings (loss) from Discontinued Operations 4,566 -4,388 -1,059Net Earnings (loss) for the Year $34,039 ($29,375) $34,827

Earnings (loss) per Common Share from Continuing Operations$0.49 ($0.42) $0.60$0.48 ($0.42) $0.58

Net Earnings (loss) per Common Share$0.56 ($0.49) $0.58$0.55 ($0.49) $0.57

References to disclosure notes have been omitted* Cott has a 52-week fiscal year

A multiple-step income statement as contained in the Cott Corporation annual report, is presented in Exhibit 3-3. In this example, the multiple-step statement presents a number of fairly idiosyncratic subtotals:

Gross profitEarnings before the undernotedEarnings(loss) before income taxesEarnings (loss) before undernoted

Click on the Income Statement to open it in Excel


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Format Issues Governed By Accounting Standards

Required Subsections Intraperiod Tax Allocation Minimum Disclosure of

Continuing Operations Discontinued Operation Extraordinary Items Unusual or Infrequent Gains

and Losses


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Required Subsections

The income statement should distinguish the following:– Income or loss before discontinued operations and

extraordinary items.– Results of discontinued operations.– Income or loss before extraordinary items.– Extraordinary items.– Net income or loss for the period.– Earnings per share, when and as appropriate.

[CICA 1520.02]

Continuing operationsincludes all of the revenues, expenses, gains, and losses that pertain to those operations except those that management has decided to sell or shut down. Discontinued operations includes past and estimated future revenues, expenses, gains, and losses on those segments of the company’s business that management has decided to get out of.Extraordinary itemsincludes only those few gains and losses that meet the criteria for classification as extraordinary.


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Intraperiod Tax Allocation

If an item is shown net of related tax, it means that the tax consequences of the item have been determined and the reported amount is shown after these tax effects have been adjusted for.

Determining this amount is the process of intraperiod tax allocation. IntraIntra means that the allocation is within the period and within the income statement and retained earnings statement.

Interperiod tax allocation is the allocation of tax expense to different reporting periods, covered in depth in Chapter 16.


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Minimum Disclosure of Continuing Operations

Section 1520 of the CICA Handbook specifies the minimum information content of the income statement included in arrivingin arriving at the income or loss before at the income or loss before discontinued operations and extraordinarydiscontinued operations and extraordinary itemsitems :

Revenue items include: revenue investment income of various types lease income revenue from government assistance


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Section 1520 list of information that the AcSB considers desirabledesirable. Major items include:

– cost of goods sold– major operating expenses categories, such

as selling and administrative expenses– rental expense– certain types of lease income– the net amount of foreign currency gains

or losses included in income– certain amounts relating to financial assets

and financial liabilities that are recognized as income or expense for the period (discussed in Chapters 13 and 15)


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Recommended disclosures of expenses include:

depreciation and amortization research and development expenses interest expenses unusual items income taxes non-controlling, or

minority, interest in income


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Discontinued Operations

Implications for predicting future income and cash flow.

In a troubled economy, sale or windup of business segments are common occurrences.

Restructuring: If the existing business is changed, but the company stays in the same line of business, a loss may be reported.

Examples of segments that, if discontinued, would require disclosure: A manufacturer eliminates a significant and distinguishable product line. A tobacco and consumer products company sells its

interest in an oil and gas joint venture, its only investment in the oil and gas industry. A food distributor who normally sells its product directly to restaurants sells its wholesale division, which sold products to retail outlets


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Discontinued Operations

Specifically, two components of income resulting from discontinued operations must be disclosed separately:– Results of operations for the

discontinued segment before the disposal decision, net of tax.

– Gain or loss (net of tax) from disposal of a segment of a business, including the income or loss from operating the business during any phase out period

Full disclosure of a discontinued operation includes the following:– Identification and description of the

business segment discontinued.– The measurement date and the actual

or projected disposal date.– The actual or expected manner of

disposition.– A description of the assets, by major

classification, of the discontinued segment.

– Revenue attributable to the discontinued segment for the reporting period.


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Extraordinary Items

Section 3480, the CICA Handbook – transactions or events that have all of the following characteristics: – They are not expected to occur frequently over several years.

– They do not typify the normal business activities of the entity.

– They do not depend primarily on decisions or determinations

by management or owners.


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Extraordinary Items

Section 3480 – Events which are not extraordinary items: Losses and provisions for losses with

respect to bad debts and inventories. Gains and losses from fluctuations in

foreign exchange rates. Adjustments with respect to contract prices. Gains and losses from write‑down or sale

of property, plant, equipment, or other investments. Income tax reductions on utilization of prior period losses or

reversal of previously recorded tax benefits. (Such reductions were once considered extraordinary and were a common example of an extraordinary item.)


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Unusual or Infrequent Gains and Losses

Some events or transactions are not extraordinary but should be disclosed separately on the income statement to emphasize their nature as unusual or infrequent.

For example, assume a timber company has a material write-down of its pulp and paper inventory and timber resources (a capital asset) due to prevailing low prices in the timber industry. – The write-down, an impairment of value, has been determined by

management but caused by outside events low market prices. – It is certainly infrequent, since the company reports that it is the first time

in the company’s 40-year history that such a write-down has been necessary.

– However, risks associated with price fluctuations in a natural resource market are surely a typical business risk in the timber industry.

– The item is not extraordinary. How should the company report the asset impairment?

The CICA Handbook recommends that companies report separately “revenues, expenses, gains or losses resulting from items that do not have all the characteristics of extraordinary items but result from transactions or events that are not expected to occur frequently over several years, or do not typify normal business activities of the entity” [CICA 1520.03(1)]. Such items should not be shown net of tax.


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Earnings Per Share

Public companies are required to report earnings per share.

Earnings per share (EPS) is a summary figure that is often quoted by analysts and investors as the primary (and sometimes only) indication of a company’s earnings record.

Public companies are required to report earnings per share for both (1) income before discontinued operations and extraordinary items, and (2) net income.


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Earnings Per Share

. Basic earnings per share is computed by dividing reported

income available to the holders of common shares by the weighted average number of common shares outstanding during the year. For computation of EPS on common shares, income must be reduced by any preferred share dividend claims since such dividends are not available to common share owners and have not been subtracted in computing income.

Fully diluted earnings per share shows how earnings per share would change in the event that all common shares promised under the terms of existing option agreements, conversion privileges on bonds or preferred shares, etc., were actually issued. We’ll study earnings per share in depth in Chapter 21


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International Perspective

Virtually every country requires an income statement of some form. The measurement basis and specific measurement rules vary, but there is

always some attempt to measure the results of operations. Income statements in non-North American reporting environments are

less revealing than in Canada. The biggest difficulty a reader has with international

financial income statements is understanding what an item means and how it was measured.

Virtually no other country other than Canada and the United States requires separate reporting of discontinued operations or effects of changes in accounting policy.

In many countries, the accounting measurement rules are greatly influenced by tax law.

The terms and labels on statements may have quite different meanings than under GAAP. Statements prepared on the entity basis of reporting are called value added statements:

reveals much more information that is of interest to other stakeholders and that is very useful for public policy. reveals the value added to the economy by the enterprise.

Canadians will recognize the concept of value added as the basis on which the much-beloved Goods and Services Tax (GST) is levied.


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Retained Earnings Statement

Error Corrections Retroactive Effect of a

Change in Accounting Policy

Capital Transactions Other Charges Appropriations of and

Restrictions on Retained Earnings

Prior Period Adjustments


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Retained Earnings Statement

The purpose of the retained earnings statement is – to report all changes in

retained earnings during the accounting period,

– to reconcile the beginning and ending balances of retained earnings, and

– to provide a connecting link between the income statement and the balance sheet.

The major components of a statement of retained earnings are:– 1. Net income or loss for the

period.– 2. Dividends.– 3. Error corrections. – 4. Cumulative effect of

retroactive changes in accounting policy.

– 5. Other changes: capital transactions, appropriations, and restrictions.


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Error Corrections

When errors are made, they must be corrected. This sometimes involves restating the financial statements of prior years,

and thus changing prior income, which is summarized in retained earnings. Proper disclosure of these changes is accomplished

by making an adjustment to opening retained earnings for the cumulative impact of the change to prior income, net of tax.

Opening retained earnings as restated are presented. Then, the comparative financial statements are adjusted

to give effect to the error correction. In effect, the transaction is backed out of the current

income statement and into the appropriate prior year. A description of the error and its effect on the financial

statements must be included in the disclosure notes.


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Retroactive Effect of a Change in Accounting Policy

The retroactive effect of a change in accounting policy is also reflected on the retained earnings statement.

When an accounting policy is changed, the comparability of the financial statements is compromised unless all comparative numbers, including prior years’ net incomes, are restated using the newly adopted principle.

This change in prior years’ income also changes opening retained earnings as previously reported.


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Capital Transactions

The retained earnings statement contains other increases and decreases in equity caused by capital transactions. Most capital transactions are share transactions.

Since a corporation is dealing with itself (its owners) in share transactions, gains and losses caused by these transactions are not shown on the income statement because they are not arm’s-length transactions.

Gains normally create contributed capital separate shareholders’ equity accounts and losses reduce retained earnings.

We’ll study these more carefully in Chapter 14.


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Other Charges

Other charges to retained earnings result from: – share issue expenses incurred on

the issuance of new shares, – taxes resulting from a change in

control or triggered by dividend payments to shareholders,

– and adjustments to retained earnings caused by a reorganization.


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Appropriations of and Restrictions on Retained Earnings

Appropriations of retained earnings result from formal decisions by the corporation to set aside, or appropriate, a specific amount of retained earnings (temporarily or permanently). The effect of an appropriation is to remove the specified amount of retained earnings from dividend availability.

Appropriations of and restrictions on retained earnings limit the availability of retained earnings to support dividends.Restrictions result from legal requirements, such as a statutory requirement that retained earnings be restricted for dividend purposes by the cost of any treasury stock held, or contractual agreements, such as a bond agreement (i.e., indenture) requiring that retained earnings of a specified amount be withheld from dividend purposes until the bonds are retired.


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Prior Period Adjustments

In the past, another category of items, called prior period adjustments were also charged to opening retained earnings, and shown net of tax on the retained earnings statement with full retroactive restatement.

These items, such as lawsuits decided in one year but pertaining to events of a prior year, or a tax reassessment related to a prior year, fit established criteria in order to qualify them for exclusion from the income statement.

The most stringent requirements were that the items had to be the result of decisions by someone other that owners or managers, and had to relate to specific prior periods.

However, in line with the all-inclusive concept of income, the AcSB decided that these items were, in fact, related to normal operations and should be recorded on the face of the income statement.

Thus, the category no longer exists.


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Review Problem

Killian CorporationIncome Statement

for the Year Ended 31 December 20x5

Revenues and gains: Sales revenue $1,000,000 Service revenue 200,000 Interest revenue 30,000 Gain on sale of operational asset 10,000 Total revenue and gains 1,330,000Expenses and losses: Cost of goods sold 600,000 Selling, general and administrative expenses 150,000 Depreciation 50,000 Interest expense 20,000 Loss on sale of long-term investment 10 Income tax expense [see computations below] 200,000 Total expenses and losses 1,030,000Income from continuing operations 300,000Discontinued operations: Loss from discontinued operations, net of tax of $4,000 ($6,000) Loss on disposal of business segment, net of tax of $24,000 -36,000 -42,000Income before extraordinary item 258,000Extraordinary item: Loss from earthquake damage, net of tax benefit of $80,000 -120,000Net income $138,000

Earnings per share: Income from continuing operations $3.00 Net income $1.38

1. Single-step income statement:Click on the Statement to Open in Excel

Computation of income tax expense:Total revenues $1,330,000Expenses before income taxes : Cost of goods sold $600,000 Selling, general and administrative expenses 150,000 Capital cost allowance (equal to depreciation) 50,000 Interest expense 20,000 Loss on sale of long-term investment 10,000 830,000Taxable income 500,000Tax rate 40%

Computation of Taxable IncomeClick on the Statement to Open in Excel

Killian CorporationIncome Statementfor the Year Ended 31 December 20x5

Sales revenue $1,000,000Cost of goods sold 600,000Gross margin 400,000Operating expenses: Selling, general and administrative expenses $150,000 Depreciation expense 50,000 200,000Income from operations 200,000Other revenues and gains: Service revenue 200,000 Interest revenue 30,000 Gain on sale of operational asset 100,000 330,000Other expenses and losses: Interest expense 20,000 Loss on sale of long-term investment 10,000 30,000Net other items 300,000Income from continuing operations before income tax 500,000Income tax expense 200,000Income from continuing operations 300,000Discontinued operations: Loss from discontinued operations, net of tax of $4,000 -6,000 Loss on disposal of business segment, net of tax of $24,000 -36,000 -42,000Income before extraordinary item 258,000Extraordinary item: Loss from earthquake damage, net of tax effects of $80,000 -120,000Net income $138,000

Earnings per share: Income from continuing operations $3.00 Net income $1.38

2. Multiple-step income statement:Click on the Statement to Open in Excel


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Summary of Key Points

Accounting income is the result of recording transactions in accordance with established measurement rules. Accounting income suffers from its reliance on transactions, which ignore economic events that indicate wealth increases. Accounting income may also be affected by the nature of accounting policies chosen, which determines the quality of earnings.

Net income must have some degree of predictive and/or feedback value for users engaged in earnings predictions. Various items on the income statement, as well as outside sources, must be carefully evaluated in the prediction process.


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Many format issues are not governed by accounting pronouncements, and the company must make choices to create an income statement that is useful to financial statement users. Minimum disclosures are recommended by the CICA Handbook; additional note disclosures and format decisions are important for full disclosure.

Two general formats for presenting income statement information not specifically regulated by accounting pronouncements are the single-step and the multiple-step formats.

The single-step format uses only two broad classifications in its presentation: a revenues and gains section and an expenses and losses section. Total expenses and losses are deducted from total revenues and gains in a single computation to determine the net income (earnings) amount.


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The multiple-step format income statement presents intermediate subtotals, designed to emphasize important relationships in the various revenue and expense categories.

Extraordinary itemsresult from transactionsor events that are infrequent,not normal business activities, and dependent on the decision of an outsider. They are required to be reported, net of income tax effects, as a separate component of income, positioned after income from continuing operations.

Unusual or infrequent items should be shown separately on the income statement, before tax.


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The gains or losses resulting from the sale or abandonment of a business segment, whose activities represent a separate major line of business or class of customer, must be reported, net of income tax effects, as a separate component of income, positioned after income from continuing operations and before extraordinary items. Gains or losses have two components: the operating results from the “decision day”, and the gain or loss on sale, which includes the actual asset sale plus operating results after the date of the decision to sell.

Earnings per share amounts relate earnings to common shares outstanding.

The statement of retained earnings reports all changes in retained earnings during the period, including net income or loss, dividends declared,

and capital transactions.


3



Error correction that affect the financial statements of prior periods are recorded (net of tax) as a change to opening retained earnings, and comparatives are restated.

A change in accounting principle is to be applied retroactively, with the cumulative effect of the change shown as an adjustment to opening retained earnings. Comparative financial statements should be restated. If this treatment is not possible, only the cumulative effect is shown on the retained earnings statement. In certain circumstances, the change in principle is reflected prospectively. An accounting estimate is changed prospectively.

b a c kn e x t h o m e thomas h. beechy schulich school of business, york university joan e. d....

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reporting income n

term income

future income

net income

earnings n economic

canada economic income

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