chapter three the income statement and comprehensive income disclosures

Chapter Three

The Income Statement and Comprehensive

Income Disclosures

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What Is Income?

• One of the most meaningful figures that a firm reports

• Significant measure of past performance

• Indicates potential for future prospects

• Relates to whether a firm is better off at the end of a period than it was at the beginning (apart from capital contributions/withdrawals)


Determining Net Income

Economic Approach:Economic Approach:

Change in net wealth due to a change in the current value of an asset

Accounting Approach:Accounting Approach:

Net income derived from business transactions


Critical Thinking

• Discussion: Consider how you measure income in your personal finances. Do you measure your income in relation to specific transactions?

• If you measure your income in relation to receipt of a paycheck or interest from your bank, then you use a transaction-based, or accounting approach.


Accrual Accounting

• Foundation for determining net income under GAAP

• Record transactions and events in the period in which they occur rather than in the period when cash or payment is received or paid

• Based on matching principle and revenue recognition principle


The Income Statement

Provides information about the amount of net income earned over a stated period of

time, detailing the revenues earned and the expenses incurred

+ Revenues

- Expenses

+ Gains

- Losses

Net Income


Income Statement: Single-Step Format

• Revenues and gains in one category

• Expenses and losses in another category

• No distinction made between operating activities and nonoperating activities

• Many variations on the single-step format are used in practice


Multiple-Step Income Statement

Operating Section• Net sales• Cost of goods sold• Gross profit• Selling/administrative

expenses• Other operating income

and expenses

Nonoperating Section• Net interest revenue or

expense • Any other nonoperating

revenues and expenses


Items That Affect Net Income

• Recurring Items: Transactions related to ongoing operating activities• Sales• Cost of sales• Administrative

expenses• Selling expense• Gains/losses on

operating assets

• Nonrecurring Items: Transactions that are unusual, infrequent, or unrelated to normal operations• Discontinued

operations• Extraordinary items• Cumulative effect of

change in accounting principle


Discontinued Operations

Presented separately from income from

continuing operations


What Constitutes a Discontinued Operation?

• Segment of a business–a subsidiary, division, or department whose assets are clearly distinguished from the firm’s other assets and operations, OR

• Component of an entity–operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity


Component of an Entity Being Held for Sale (Or Sold)

• Qualifies as a discontinued operation if:• Operations and cash flows of component will be (or

have been) eliminated from the ongoing operations of the firm

• Entity will not have significant continuing involvement in the operations of the component

• If component qualifies as a discontinued operation: • Report both revenues or losses from operations of

the component plus any gain or loss on its disposal separately from income from continuing operations, net of tax


Extraordinary Items

• Unusual• High degree of abnormality• Unrelated to ordinary activities of the firm

• Infrequent• Not expected to recur in the foreseeable

future given the nature of the firm’s environment

• Material• Large enough to make a difference in

investors’ decisions


Accounting Changes

• A switch or change in accounting principle that is either chosen by management or mandated by the FASB or SEC

• A modification or change in an accounting estimate

• The correction of an error, which, although not technically an accounting change, is treated in a similar manner


Types of Accounting Changes


Change in Accounting Principle

• Cumulative effect of change on prior years’ earnings reported net of tax after income from continuing operations

• Effect of change on current year’s earnings reported in continuing operations

• Carrying value of the asset or liability associated with the change is recalculated and adjusted


Change in Accounting Estimate

• If changing the estimated life of an asset• Calculate new depreciation schedule• Record new depreciation expense

incorporating the change in current period

• If revising the amount of uncollectible accounts• Make change in current period as an

adjustment to bad debt expense in ordinary operating income


Error Correction

• Illustration: Assume Angel Co. neglected to record equipment depreciation of $15,000 per year for the past two years. Assume the company’s tax rate is 35 percent. How is this error corrected?

Retained Earnings [$30,000 x (1 - .35)] 19,500Income Tax Refund Receivable ($30,000 x .35) 10,500 Accumulated Depreciation 30,000


Intraperiod Tax Allocation

• The practice of relating income tax expense to the specific item or event that cause the tax

• On the income statement, report income tax resulting from continuing operations as a separate line. Report nonrecurring items (discontinued operations, extraordinary items, and cumulative effect of change in accounting principle) net of their tax effects


Earnings Per Share

• The amount of earnings associated with each share of common stock

EPS =Net Income-Preferred Stock Dividends

Weighted-Average Number of Common Shares Outstanding


Reporting Earnings Per Share

• Statement of Financial Accounting Standards No. 128 requires that EPS be reported for:

• Income from continuing operations• Discontinued operations• Extraordinary items• Cumulative effects of a change in

accounting principle• Net income


Comprehensive Income

• Income resulting from transactions that are primarily derived from events external to the firm:• Unrealized gains/loss on marketable

securities held in the available-for-sale portfolio (Ch. 11)

• Unrealized gains/losses resulting from foreign currency translations

• Amounts that result from recording the minimum pension obligation (Ch. 15)


Reporting Comprehensive Income

• Components of comprehensive income may be reported in one of the following ways:• One statement—net income and

comprehensive income are added together to obtain total comprehensive income

• Two statements—net income reported on one statement and comprehensive income reported on another statement

• Report comprehensive income as part of the statement of changes in stockholders’ equity


Analyzing the Income Statement

• Commonly used measurements:• Gross Profit• Gross Profit Percentage• Operating Margin• Operating Margin Percentage• Profit Margin on Sales


Gross Profit

• Amount earned before operating expenses

• Gross Profit = Net Sales – Cost of Sales

Dell Computer CorporationExcerpt from Consolidated Statements of Income

Fiscal Year Ended January 1, 2003(in millions)

Net revenue $35,404Cost of revenue 29,055 Gross margin 6,349


Gross Profit Percentage

• Amount (expressed as percentage) of gross profit earned on each dollar of sales

• Gross Profit Percentage = Gross Profit Net Sales



Net revenue $35,404Cost of revenue 29,055 Gross margin 6,349

$6,349 million $35,404 million=

17.93 percent


Operating Margin

• Amount the firm generates after operating expenses and cost of sales (also called operating income)

• Net Sales – (Cost of Sales + Operating Expenses)



Net revenue $35,404Cost of revenue 29,055 Gross margin 6,349 Total operating expenses 3,505 Operating income 2,844


Operating Margin Percentage

• Indicates how much operating margin is generated on each dollar of sales

• Operating Margin Net Sales

Dell Computer CorporationConsolidated Statements of IncomeFiscal Year Ended January 1, 2003(in millions)

Net revenue $35,404Cost of revenue 29,055 Gross margin 6,349 Total operating expenses 3,505Operating income 2,844

$2,844 million $35,404 million =

8.03 percent


Profit Margin on Sales

• Amount of net income earned on each dollar of sales

• Net Income Net Sales

Dell Computer Corporation

Year Ended January 31, 2003

$2,122 million $35,404 million = 5.99 percent


Check Your Understanding

Q What is accrual accounting?

A Accrual accounting dictates that transactions and other events and circumstances are recorded in the period in which they occur rather than in the period in which cash or some other form of payment is received or paid.



Q If your company prefers to separate operating from nonoperating activities on its income statement, which format would be used?

A The multiple-step format divides operating from nonoperating items.



Q What are the three characteristics that define an extraordinary item?

A Extraordinary items are unusual, infrequent, and material.



Q How do you determine whether a component of an entity that is being held for sale can be considered a discontinued operation?

A The component can be considered a discontinued operation:

(1) if the operations and cash flows of the component will be eliminated from the ongoing operations of the entity, and

(2) the entity will not have any significant continuing involvement in the operations of the component.



Q If a change has been made to an accounting estimate, how is this change reflected on the income statement?

A The cumulative effect of the change on prior years’ earnings is reported net of tax after income from continuing operations. The effect of the change on the current year’s earnings are reported in continuing operations.



Q Why is EPS an important measurement to investors and analysts?

A EPS indicates, on a per share basis, the income of the current period for both the recurring and the nonrecurring items that are associated with the common shareholders’ ownership interest.



Q List items that would be considered nonrecurring on the income statement.

A Discontinued operations, extraordinary itmes, and the cumulative effect of a change in accounting principle would be considered nonrecurring items.

chapter three the income statement and comprehensive income disclosures

Documents

operating income

net income recurring

net income economic

multiplestep income

accounting principle

practice slide

business transactions

net wealth