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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

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Chapter 11 l.jpg

Chapter 11

The Income Statement & The Statement of Stockholders’ Equity


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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


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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


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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

Income Statement


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Accounting Principles

  • Matching

  • Revenue Realization


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Allied Electronics Corporation

Income Statement

Year Ended December 31, 20x5

Sales revenue $500,000

Cost of goods sold –240,000

Gross margin $260,000

Operating expenses 181,000

Operating income $ 79,000

Income Statement - Continuing Operations


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Income Statement - Continuing Operations

Operating income $79,000

Other gains (losses):

Loss on restructuring operations ( 8,000)

Gain on sale of machinery 19,000

Income from continuing operations

before income tax $90,000

Income tax expense 36,000

Income from continuing operations $54,000


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Income Statement - Special Items

Discontinued operations: $35,000,

less income tax of $14,000 21,000

Income before extraordinary items

and cumulative effect of change

in depreciation method $75,000

Extraordinaryflood loss, $20,000,

less income tax savings of $8,000 (12,000)

Cumulative effect of change in

depreciation method, $10,000,

less income tax of $4,000 6,000

Net income $69,000


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Income from Continuing Operations

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

  • Used to predict future income.


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Predicting Future Profits

Estimated annual

income in the future

Estimated value of

Common Stock

=

Investment

capitalization rate



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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


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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


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Discontinued Operations

  • Segment – identifiable division of a company

    • Sold or

    • Closed


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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)


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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


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Earnings Per Share

Net Income

-

Preferred dividends

Earnings per share

=

  • 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)

Average number of shares of common outstanding


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Income Statement - Earnings per Share

Earnings per share of common stock

(20,000 shares outstanding):

Income from continuous operations

(54000)/20000 $2.70

Income from discontinued operations

(21000/20000) 1.05

Income before extraordinary item

and cumulative effect of change

in depreciation method

(75000/20000) $3.75

Extraordinary loss

(12000/20000) (0.60)

Cumulative effect of change in

depreciation method

(6000/20000) 0.30

Net income

(69000/20000) $3.45


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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.


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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


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Income before income tax (from the

income statement)

Income

tax

expense

Income

Tax Rate

=

X

Taxable income from the income tax return

filed with the IRS

Income

tax

payable

Income

Tax Rate

=

X

Corporate Income Taxes

  • Must measure

    • Income tax expense

    • Income tax payable


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Corporate Income Taxes

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


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Accounting for CorporateIncome Taxes

  • 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%.


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Accounting for CorporateIncome Taxes

Dec 31Income Tax Expense ($900 x .40) 360

Income Tax Payable ($800 x .40) 320

Deferred Tax Liability 40

Recorded income tax for the year

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


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Accounting for CorporateIncome Taxes

Income statement

Income before income tax $900

Income tax expense 360

Net income $540

Balance sheet

Current Liabilities:

Income tax payable $320

Long-term liabilities:

Deferred tax liability 40*

Total $360

*Assumes beginning tax liability was zero.


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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.


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CNN Corporation

Statement of Retained Earnings

Year Ended December 31, 2005

Retained Earnings, Dec. 31, 2004 (original) $390,000

Prior-period adjustment – debit to correct error

in recording income tax expense of 2004 ( 10,000)

Retained earnings, Dec. 31, 2004, adjusted $380,000

Net income for 2005 114,000

Total $494,000

Deduct: 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


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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


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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



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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


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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


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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


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