Chapter 11

The Income Statement & The Statement of Stockholders’ Equity

Learning Objectives

Analyze a complex income statement Account for a corporation’s income tax Analyze a statement of stockholders’

equity Understand managers’ and auditors’

responsibilities for the financial statements

Income Statement

Periodically Prepared to report Financial Consequences of Activities Undertaken– By Accounting Entity– Within a Certain Period of Time

Profit– More resources available at end-of-period then

beginning-of-period Loss

– Consumed more resources by the end-of-period then it generated

Income Statement

Summary of Revenues and Expenses

For a Specific Period of Time Grouped by Class

– Sales Returns and Allowances Discounts

– Cost of Goods Sold– Gross Margin/Profit– Operating Expenses

Selling Expenses– Salaries– Advertising– Travel– Telephone– Supplies– Depreciation

– Administrative Salaries Telephone Legal & Professional Supplies Depreciation – Bldg & Equip Misc.

– Net Income from Operations– Other

Interest Expense Interest Income

– Discontinued Operations– Extraordinary Events– Cumulative Effect of Change– Net Income– Earnings Per Share

Accounting Principles

Matching Revenue Realization

Income Statement - Continuing Operations

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

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 Operations

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 Items

Income from Continuing Operations

A measure of the part of the business expected to be ongoing.

Used to predict future income.

Predicting Future Profits

Estimated value ofCommon Stock =

Estimated annualincome in the future

Investmentcapitalization rate

If estimated value of the company:

Decision

Exceeds Current marketValue of the

Company

Buy the stockEquals Hold the stockIs less than Sell the stock

Estimated Value of Common Stock

Cap Rate Est Value Mke ValueOperating Income 79,000 0.12 658,333 513,000 Income from Continuting Opeations 54,000 0.12 450,000 513,000

Market Value Common Shares Outstanding 108,000 Market Price per share 4.75

513,000

Continuing Operations

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

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

Other Income Statement Items

Discontinued Operations Extraordinary Gains and Losses

(Extraordinary Items)– Must be both infrequent

seldom happening or occurring – and Unusual

not ordinarily encountered Cumulative Effect of a Change in Accounting

Method

Discontinued Operations

Segment – identifiable division of a company– Sold or– Closed

Extraordinary Items

Unusual for the company and infrequent– Losses due to natural disasters– Expropriations

the action of the state in taking or modifying the property rights of an individual in the exercise of its sovereignty

An Exception– Material gains/losses from extinguishment of debt

(to be reported as extraordinary item)

Cumulative Effect of a Change in Accounting Principle

From double-declining-balance (DBB) to straight-line depreciation

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

Report in a special section of the income statement after extraordinary items

Earnings Per ShareEarnings per share =

Net Income - Preferred dividends

Average number of shares of common outstanding

• Earnings per share is disclosed separately for:– continuing operations– discontinued operations (do not subtract pfd)– Extraordinary items (don not subtract pfd)– Cumulative effect of change in accounting

method (do not subtract pfd)

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

Income from continuous operations(54000)/20000 $2.70Income from discontinued operations(21000/20000) 1.05Income before extraordinary item and cumulative effect of change in depreciation method(75000/20000) $3.75Extraordinary loss(12000/20000) (0.60)Cumulative effect of change in depreciation method(6000/20000) 0.30

Net income(69000/20000) $3.45

Income Statement - Earnings per Share

Earnings Per Share

Effect of preferred stock– preferred dividends must be paid before

distributions of earnings to common stockholders.

Dilution– Convertible items could result in diluted eps.– Diluted EPS is disclosed on the income

statement.

Comprehensive Income

Change in total stockholders’ equity from all sources other than from the owners of the business.– Unrealized gains (losses) on available-for-

sale investments– Foreign-currency translation adjustments

Corporate Income Taxes• Must measure

– Income tax expense– Income tax payable

Incometax

expense=

Income before income tax (from the

income statement)X

IncomeTax Rate

Incometax

payable

=Taxable income from the income tax return

filed with the IRSX Income

Tax Rate

Corporate Income Taxes

Difference between income tax expense and income tax payable is a deferred tax liability or deferred tax asset.

Suppose for 20x5, Nike, Inc., has pretax accounting income of $900 million on the income statement.

Taxable income is $800 million on the company’s income tax return.

The tax rate is 40%.

Accounting for CorporateIncome Taxes

Accounting for CorporateIncome 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

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 CorporateIncome Taxes

Retained Earnings

Prior period adjustments– corrections of errors that occurred in prior

periods. Since the temporary accounts have

been closed to retained earnings, errors from prior periods must be made to retained earnings.

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 Adjustment

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

Restrictions on Retained Earnings

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

Creditors may restrict a corporation’s dividend payments and treasury stock purchases

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

Statement of Stockholders’ Equity

Reports all changes in equity for the period. Issuance of stock Net income Cash dividends Stock dividends Treasury stock transactions Accumulated other comprehensive income

Accumulated Other

Comprehensive Income

Common Stock $1 Par

Additional Paid-in Capital

Retained Earnings

Treasury Stock

Unrealized Gain

(loss) on Investments

Foreign- Currency

Translation Adjustment

Total Stockholders’

Equity

Balance, Dec 31, 20X4 $80,000 $160,000 $130,000 $(25,000) $6,000 $(10,000) $341,000 Issuance of stock 20,000 65,000 85,000

Net Income 69,000 69,000 Cash Dividends (21,000) (21,000)

Stock dividends – 8% 8,000 26,000 (34,0000 -0- Purchase of Treasury Stock (9,000) (9,000)

Sale of Treasury Stock 7,000 4,000 11,000 Unrealized gain on investments 1,000 1,000

Foreign-currency translation adjustment

3,000 3,000

Balance, Dec 31, 20X5 $108,000 $258,000 $144,000 $(30,000) $7,000 $ (7,000) $480,000

Statement of Stockholders’ Equity

Responsibility for theFinancial Statements

Management – issues a statement of responsibility with

financial statements– declares responsibility for financial

statements and states that they conform to GAAP

Auditor Report

Typically contains three paragraphs: Identifies the audited financial statements Describes how the audit was performed States the auditor’s opinion -financial

statements conform to GAAP and people can rely on them for decision making

Auditor Report

Unqualified (Clean)– the financial statements presented are free of material

misstatements and are in accordance with GAAP Qualified

– the financial statements are fairly presented with a certain exception which is otherwise misstated

Adverse– the information contained is materially incorrect, unreliable, and

inaccurate in order to assess the auditee’s financial position and results of operations

Disclaimer– the auditor could not form, and consequently refuses to present, an

opinion on the financial statements