Chapter 5

Income Statement & Related Information

Income Statement

• Revenues: inflows from major operations• Expenses: outflows from major operations• Gains & Losses: changes in equity from

peripheral activities• Non-recurring items• Net income: bottom line all operating activities

recorded on the income statement• Comprehensive income: Changes in equity from

all non-owner sources (note: usually not reported on the income statement

Income Statement Usefulness

Evaluate past performance.

Predicting future performance.

Help assess the risk or uncertainty of achieving future cash flows.

Income Statement Limitations

Companies omit items that cannot be measured reliably.

Income is affected by the accounting methods employed.

Income measurement involves judgment.

Earnings Quality

• Companies have incentives to manage income to meet or beat Wall Street expectations, so that

the market price of stock increases and

the value of stock options increase.

• Quality of earnings is reduced if earnings management results in information that is less useful for predicting future earnings and cash flows.

Revenue

• Revenues – Inflows or other enhancements of assets or settlements of its liabilities that constitute the entity’s ongoing major or central operations.

Sales

Fee Revenue (services, etc.)

Interest Revenue

Dividend Revenue

Rent Revenue

Expenses

• Outflows or other using-up of assets or incurrences of liabilities that constitute the entity’s ongoing major or central operations.

Expenses by Category

• Cost of goods sold (manufacturing, retail)• Cost of sales (services or services included)• Operating expenses (selling, general &

administrative, research & development, other)

• Interest income & expenses • Provision for tax

Gains & Losses

•Gains – Increases in equity (net assets) from peripheral or incidental transactions.

•Losses - Decreases in equity (net assets) from peripheral or incidental transactions.

• Gains and losses can result from

sale of investments or plant assets,

settlement of liabilities,

write-offs of assets.

Non-recurring Items

• Extraordinary items• Discontinued operations• Accounting changes Change in accounting principle Change in accounting estimate Correction of an error

Single Step Income Statement

Income Statement (in thousands)

Revenues:

Sales ####

I nterest revenue 17,000

Total revenue ####

Expenses:

Cost of goods sold 149,000

Advertising expense 10,000

Depreciation expense 43,000

I nterest expense 21,000

I ncome tax expense 24,000

Total expenses ####

Net income ####

Earnings per share 0.75$

Multiple Step Income Statement

Separates operating transactions from non-operating transactions.

Matches costs and expenses with related revenues.

Highlights certain intermediate components of income that analysts use.

Multiple Step Income StatementIncome Statement (in thousands)

Sales ####

Cost of goods sold 149,000

Gross profit 136,000

Operating expenses:

Advertising expense 10,000

Depreciation expense 43,000

Total operating expense53,000

Income from operations83,000

Other revenue (expense):

I nterest revenue 17,000

I nterest expense (21,000)

Total other (4,000)

I ncome bef ore taxes 79,000

I ncome tax expense 24,000

Net income ####

Earnings per share 0.75$

Non-recurring & Other Irregular Items

• Companies are required to report irregular items in the financial statements so users can determine the long-run earning power of the company. (Irregular items for 600 companies, 1 Year.)

Discontinued Operations

• Discontinued Operations occur when,

– (a) company eliminates the

results of operations and

cash flows of a component.

(b)there is no significant continuing involvement in that component.

• Amount reported “net of tax” (intra-period tax allocation).

Extraordinary Items

• Extraordinary items are nonrecurring material items that differ significantly from a company’s typical business activities. With SFAS #145-relatively rare.

• Extraordinary Item must be both of an

Unusual nature and Occur infrequently

• Company must consider the environment in which it operates.

• Amount reported “net of tax.”

Unusual Gains & Losses

• Material items that are unusual or infrequent, but not both, should be reported in a separate section just above “Income from continuing operations before income taxes.” These are not non-recurring items.

• Examples can include:

Write-downs of inventories

Foreign exchange transaction gains and losses

• The Board prohibits net-of-tax treatment for these items.

Changes in Accounting Principle

Retrospective adjustment

Cumulative effect adjustment to beginning retained earnings

Approach preserves comparability

Examples include:change from FIFO to average costchange from the percentage-of-completion to

the completed-contract method

Changes in Estimate

Accounted for in the period of change and future periods

Not handled retrospectively

Not considered errors or extraordinary items

Examples include:Useful lives and salvage values of depreciable

assetsAllowance for uncollectible receivables Inventory obsolescence

Correction of an Error

Result from: mathematical mistakes mistakes in application of accounting principles oversight or misuse of facts

Corrections treated as prior period adjustments

Adjustment to the beginning balance of retained earnings

Tax Allocation

Tax Allocation Result from: mathematical mistakes mistakes in application of accounting principles oversight or misuse of facts

Corrections treated as prior period adjustments

Adjustment to the beginning balance of retained earnings

Tax affect is reported within the line item.

Inter-period Tax Allocation is the timing difference between GAAP and tax accounting; for example, most companies use straight-line depreciation for financial reporting and accelerated for tax purposes

Earnings Per Share (EPS)

• Calculation:– Net income - Preferred dividends

Weighted average number of shares outstanding

An important business indicator.

Measures the dollars earned by each share of common stock.

Must be disclosed on the income statement.

Changes in Retained Earnings

Increases:

Net income

Change in accounting principle Error corrections

Decreases:

Net loss

Dividends Change in accounting principles Error corrections

All-Inclusive Income

• Net income is considered “modified” all-inclusive income

• All-inclusive is Comprehensive Income• Some companies report comprehensive

income as part of the income statement• For most companies, comprehensive income

has to be calculated.

Other Comprehensive Income

Gains & losses not reported on the income statement (also called “dirty surplus):Unrealized gains and losses on available-for-sale securities.Translation gains and losses on foreign currency.Pension & derivatives gains & lossesOther

Comprehensive Income

• Usually reported at part of the statement of stockholders’ equity.

Comprehensive Income

• Balance Sheet presentation (part of stockholders’ equity):

Earnings Measures

• Gross profit• Operating income• Income before tax• Earnings before income & taxes (EBIT)• Income from continuing operations• Net income• Comprehensive income