Chapter 5
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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

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Chapter 5

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Chapter 5

Chapter 5

Income Statement & Related Information


Income statement

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

Income Statement Usefulness

  • Evaluate past performance.

  • Predicting future performance.

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


Income statement limitations

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

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

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

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

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 & 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

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

Single Step Income Statement


Multiple step income statement

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 statement1

Multiple Step Income Statement


Non recurring other irregular items

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

  • Discontinued Operations occur when,

    • (a) company eliminates the

      • results of operations and

      • cash flows of a component.

    • there is no significant continuing involvement in that component.

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


Extraordinary items

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 environmentin which it operates.

  • Amount reported “net of tax.”


Unusual gains losses

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

Changes in Accounting Principle

  • Retrospective adjustment

  • Cumulative effect adjustment to beginning retained earnings

  • Approach preserves comparability

  • Examples include:

    • change from FIFO to average cost

    • change from the percentage-of-completion to the completed-contract method


Changes in estimate

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 assets

    • Allowance for uncollectible receivables

    • Inventory obsolescence


Correction of an error

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

  • 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

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

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

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

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 & losses

  • Other


Comprehensive income

Comprehensive Income

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


Comprehensive income1

Comprehensive Income

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


Earnings measures

Earnings Measures

  • Gross profit

  • Operating income

  • Income before tax

  • Earnings before income & taxes (EBIT)

  • Income from continuing operations

  • Net income

  • Comprehensive income


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