the income statement and statement of cash flows

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

The Income Statement and Statement of Cash Flows

4

4-2

Learning Objectives

Explain the difference between net income and comprehensive income and how we report

components of the difference.

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Comprehensive Income

An expanded version of income that includes four types of gains and

losses that traditionally have not been included

in income statements.

4-4

Other Comprehensive Income

Statement of Financial Accounting Standards No. 130

Comprehensive income includes traditional net income and changes in equity from nonowner transactions.

Statement of Financial Accounting Standards No. 130

Comprehensive income includes traditional net income and changes in equity from nonowner transactions.

1. Changes in the market value of securities available for sale (described in Chapter 12).

2. Gains, losses, and amendment costs for pensions and other postretirement plans (described in Chapter 17).

3. When a derivative is designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction (described in Chapter 14).

4. Gains or losses from changes in foreign currency exchange rates (discussed elsewhere in your accounting curriculum).

1. Changes in the market value of securities available for sale (described in Chapter 12).

2. Gains, losses, and amendment costs for pensions and other postretirement plans (described in Chapter 17).

3. When a derivative is designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction (described in Chapter 14).

4. Gains or losses from changes in foreign currency exchange rates (discussed elsewhere in your accounting curriculum).

4-5

Accumulated Other Comprehensive Income

In addition to reporting comprehensive income that occurs in the current period, we must also report these amounts on a cumulative basis in the balance sheet as

an additional component of shareholders’ equity.

In addition to reporting comprehensive income that occurs in the current period, we must also report these amounts on a cumulative basis in the balance sheet as

an additional component of shareholders’ equity.

(In millions, except shares) 2004 2003Common Stockholders' Investment:Common stock, $.10 par value, 800 million shares authorized, 300 million shares issued for 2004 and 299 million shares 30$ 30$ issued for 2003Additional paid-in capital 1,079 1,088 Retained earnings 7,001 6,250 Accumulated other comprehensive loss (46) (30)

8,064 7,338 Less deferred compensation and treasury stock at cost 28 50 Total common stockholders' investment 8,036$ 7,288$

FedEx CorporationBalance Sheet

31-May

4-6

Learning Objectives

Discuss the importance of income from continuing operations and describe its

components.

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Expenses

Outflows of resources incurred in generating revenues.

Revenues

Inflows of resources resulting

from providing goods or

services to customers.

Gains and Losses

Increases or decreases in equity from

peripheral or incidental

transactions of an entity.

Income from Continuing OperationsIncome from Continuing Operations

Income Tax Expense

Because of its

importance and size,

income tax expense is a

separate item.

4-8

Operating Income

Nonoperating Income

Operating Income Versus Nonoperating Income

Includes revenues and expenses

directly related to the principal

revenue-generating

activities of the company

Includes gains and losses and

revenues and expenses related to peripheral or

incidental activities of the

company

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Income Statement (Single-Step)

Expenses & Losses {

{Revenues & Gains

{Proper Heading

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Income Statement (Multiple-Step)

{Non- operating Items

{Gross Profit

{Proper Heading

Operating Expenses {

4-11

Learning Objectives

Describe earnings quality and how it is impacted by management practices to

manipulate earnings.

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Earnings Quality

Earnings quality refers to the ability of reported earnings to predict a company’s future.

The relevance of any historical-based financial statement hinges on its

predictive value.

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Manipulating Income and Income Smoothing

“Most managers prefer to report earnings that follow a smooth, regular, upward path.”1

Two ways to manipulate income:

1. Income shifting

2. Income statement classification

1 Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p. 168.

4-14

Learning Objectives

Discuss the components of operating and nonoperating income and their relationship to

earnings quality.

4-15

Operating Income and Earnings Quality

Should all items of revenue and expense included in operating income be considered indicative of a

company’s permanent earnings?

No, not necessarily.

Operating expenses may include the following unusual items that may or may not continue in the future:

• Restructuring costs

• Goodwill impairment

• Long-lived asset impairment

• In-process research and development

4-16

Operating Income and Earnings Quality

Restructuring CostsCosts associated with shutdown or

relocation of facilities or downsizing of operations are

recognized in the period incurred.

Goodwill Impairment and Long-lived Asset

Impairment

Involves asset impairment losses or charges (discussed further in

Chapters 10 & 11).

In-process Research and Development

Results from certain business combinations (discussed further in

Chapter 10).

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Nonoperating Income and Earnings Quality

Gains and losses from the sale of operational assets and investments often can significantly

inflate or deflate current earnings.

ExampleAs the stock market boom reached its

height late in the year 2000, many companies recorded large gains from

sale of investments that had appreciated significantly in value.

How should those gains be interpreted in terms of their relationship to

future earnings? Are they transitory or permanent?

4-18

Pro Forma Earnings

Companies often voluntarily provide a pro forma earnings number when they announce annual or

quarterly earnings. Pro forma earnings are management’s assessment of permanent earnings.

The Sarbanes-Oxley Act Section 401 requires a

reconciliation between pro forma earnings and

earnings determined according to GAAP.

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Separately Reported Items

Reported separately, net of taxes:

Discontinued operations

$ xxxxx

xxx

xx

xxNet Income $ xxx

Extraordinary items (net of $xx in taxes)

Income from continuing operations before income taxes and extraordinary itemsIncome tax expenseIncome from continuing operations before extraordinary itemsDiscontinued operations (net of $xx in taxes)

Extraordinary items

A third item, the cumulative effect of

a change in accounting

principle, was eliminated from

separate reporting by a new

accounting standard in 2005.

4-20

Intraperiod Income Tax Allocation

Income Tax Expense must be associated with each component of income that causes it.

Income Tax Expense must be associated with each component of income that causes it.

Show Income Tax Expense related to

Income from Continuing Operations.

Show Income Tax Expense related to

Income from Continuing Operations.

Report effects of Discontinued Operations and Extraordinary Items

NET OF RELATED INCOME TAXES.

Report effects of Discontinued Operations and Extraordinary Items

NET OF RELATED INCOME TAXES.

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Learning Objectives

Define what constitutes discontinued operations and describe the appropriate income statement presentation for these

transactions.

4-22

A discontinued operation is the sale or disposal of a component of an entity.

A component comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity.

A component could include: Reportable segments Operating segments Reporting units Subsidiaries Asset groups

Discontinued Operations

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Report results of operations separately if two conditions are met:

The operations and cash flows of the

component have been (or will be) eliminated

from the ongoing operations.

The entity will not have any significant

continuing involvement in the operations of the

component after the disposal transaction.

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Reporting for Components Sold

Operating income or loss of the component from the beginning of the reporting period to

the disposal date.

Gain or loss on the disposal of the

component.

Reporting for Components Held For Sale

Operating income or loss of the component from the beginning of the reporting period to the end of the reporting

period.

An “impairment loss” if the carrying value of

the assets of the component is more than the fair value minus cost to sell.

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During the year, Apex Co. sold an unprofitable component of the company. The

component had a net loss from operations during the period of $150,000 and its assets

sold at a loss of $100,000. Apex reported income from continuing operations of $128,387. All items are taxed at 30%.

How will this appear in the income statement?

Discontinued Operations Example

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Computation of Loss from Discontinued Operations (Net of Tax Effect):

4-27

Income Statement Presentation:


4-28

Learning Objectives

Define extraordinary items and describe the appropriate income statement presentation for

these transactions.

4-29

Material events or transactions

Unusual in nature Infrequent in occurrence Reported net of related

taxes

Extraordinary Items

4-30

During the year, Apex Co. experienced a loss of $75,000 due to an earthquake at one

of its manufacturing plants in Nashville. This was considered an extraordinary item.

The company reported income before extraordinary item of $128,387. All gains and losses are subject to a 30% tax rate.

How would this item appear in the income statement?

Extraordinary Items Example

4-31

Income Statement Presentation:

Extraordinary Items ExampleComputation of Loss from Extraordinary Item (Net of Tax Effect):

4-32

Unusual or Infrequent Items

Items that are material and are either unusual or infrequent—but not both—

are included as a separate item in continuing operations.

4-33

Type of Accounting Change Definition

Change in Accounting Principle

Change from one GAAP method to another GAAP method

Change in Accounting Estimate

Revision of an estimate because of new information or new experience

Change in Reporting Entity

Preparation of financial statements for an accounting entity other than the entity that existed in the previous period

Accounting Changes

4-34

Learning Objectives

Describe the measurement and reporting requirements for a change in accounting

principle.

4-35

Change in Accounting Principle

Occurs when changing from one GAAP method to another GAAP method For example, a change from LIFO to FIFO

Voluntary changes in accounting principles are accounted for retrospectively by revising prior years’ financial statements.

Changes in depreciation, amortization, or depletion methods are accounted for the same way as a change in accounting estimate.

4-36

Learning Objectives

Explain the accounting treatments of changes in estimates and correction of errors.

4-37

Change in Accounting Estimate

Revision of a previous accounting

estimate

Use new estimate in current and future

periods

Includes treatment for changes in depreciation,

amortization, and depletion methods

4-38

Change in Accounting Estimate Example

On January 1, 2003, we purchased equipment costing $30,000, with a useful

life of 10 years and no salvage value. During 2006, we determine that the

remaining useful is 5 years (8-year total life). We use straight-line depreciation.

Compute the revised depreciation expense for 2006.

4-39

Asset cost 30,000$ Accumulated depreciation 12/31/05 - ($3,000 × 3 years) (9,000) Remaining to be depreciated 21,000 Remaining useful life ÷ 5 yearsRevised annual depreciation 4,200$

Record depreciation expense of $4,200 for2006 and subsequent years.

Change in Accounting Estimate Example

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If two entities combine, a single

set of consolidated financial

statements is generally required.

4-41


A change in reporting entity is reported by restating all previous

periods’ financial statements presented

for comparative purposes as if the new reporting entity existed

in those periods.

4-42

Corrections of errors from a previous period

Appear in the Statement of Retained Earnings as an adjustment to beginning retained earnings

Must show the adjustment net of income taxes

Prior Period Adjustments

4-43

Prior Period Adjustments Example

While reviewing the depreciation entries for 2002-2007, the controller found that in 2006

depreciation expense was incorrectly debited for $150,000 when in fact it should have been

debited $125,000. (Ignore income taxes.)

Prepare the necessary journal entry in 2007 to correct this prior period error.

4-44

Prior Period Adjustments Example

4-45

Learning Objectives

Define earnings per share (EPS) and explain required disclosures of EPS for certain income

statement components.

4-46

Earnings Per Share Disclosure

One of the most widely used ratios is earnings per share (EPS), which shows the amount of income

earned by a company expressed on a per share basis.

Basic EPS

Net income less preferred dividends

Weighted-average number of common shares outstanding for the

period

Diluted EPS

Reflects the potential dilution that could occur for companies that have certain

securities outstanding that are convertible into common shares or stock options that could create additional common shares if

the options were exercised.

4-47

Earnings Per Share Disclosure

Report EPS data separately for:

1. Income from Continuing Operations

2. Separately Reported Items

a) Discontinued Operations

b) Extraordinary Items

3. Net Income

4-48

Learning Objectives

Describe the purpose of the statement of cash flows.

4-49

The Statement of Cash Flows

Provides relevant information about a company’s cash receipts and cash disbursements.

Helps investors and creditors to assess future net cash flows liquidity long-term solvency.

Required for each income statement period presented.

4-50

Learning Objectives

Identify and describe the various classifications of cash flows presented in a statement of cash

flows.

4-51

Operating Activities

Cash Flows from


Cash Flows from


Inflows from: Sales to customers. Interest and dividends

received.

Inflows from: Sales to customers. Interest and dividends

received. +

Outflows to: Purchase of inventory. Salaries, wages, and other

operating expenses. Interest on debt. Income taxes.

Outflows to: Purchase of inventory. Salaries, wages, and other

operating expenses. Interest on debt. Income taxes.

_

4-52

Direct and Indirect Methods of Reporting

Two Formats for Reporting Operating Activities

Reports the cash effects of each

operating activity

Direct Method

Starts with accrual net income and

converts to cash basis

Indirect Method

4-53

Direct and Indirect Methods

Cash flows from Operating ActivitiesCash received from customers 78$ Cash paid for administrative expenses (25)

Net cash flows from operating activities 53$

ARLINGTON LAWN CAREStatement of Cash Flows

For the Year Ended December 31, 2006($ in thousands) Direct

Method

Cash flows from Operating ActivitiesNet income 35$ Adjustments for noncash effects:

Depreciation expense 8$ Increase in accounts receivable (12) Increase in accounts payable 7 Increase in income taxes payable 15 18

Net cash flows from operating activities 53$

ARLINGTON LAWN CAREStatement of Cash Flows

For the Year Ended December 31, 2006($ in thousands)

Indirect Method

4-54

Cash Flows from

Investing Activities

Cash Flows from


+


Inflows from: Sale of long-term assets used in

the business. Sale of investment securities

(stocks and bonds). Collection of nontrade

receivables.

Inflows from: Sale of long-term assets used in

the business. Sale of investment securities

(stocks and bonds). Collection of nontrade

receivables.

_

Outflows to: Purchase of long-term assets

used in the business. Purchase of investment

securities (stocks and bonds). Loans to other entities.

Outflows to: Purchase of long-term assets

used in the business. Purchase of investment

securities (stocks and bonds). Loans to other entities.

4-55

Cash Flows from

Financing Activities

Cash Flows from


+

_


Inflows from: Sale of shares to owners. Borrowing from creditors

through notes, loans, mortgages, and bonds.

Inflows from: Sale of shares to owners. Borrowing from creditors

through notes, loans, mortgages, and bonds.

Outflows to: Owners in the form of dividends

or other distributions. Owners for the reacquisition of

shares previously sold. Creditors as repayment of the

principal amounts of debt.

Outflows to: Owners in the form of dividends

or other distributions. Owners for the reacquisition of

shares previously sold. Creditors as repayment of the

principal amounts of debt.

4-56

Noncash Investing and Financing Activities

Significant investing and financing transactions not involving cash also

are reported.

Acquisition of equipment (an investing activity) by issuing a long-term note payable (a financing

activity).

4-57

End of Chapter 4

the income statement and statement of cash flows

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