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Chapter 6. The Income Statement and Measures of Performance. Chapter 6--Learning Objectives. 1. Explain the different concepts of income, cash, economic, and accrual-based income measures . Concepts of Income. Cash Basis Economic Accrual Basis. Cash Basis Income.

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Chapter 6

The Income Statementand Measures of Performance


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Chapter 6--Learning Objectives

1. Explain the different concepts of income, cash, economic, and accrual-based income measures


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Concepts of Income

Cash Basis

Economic

Accrual Basis


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Cash Basis Income

Income = Cash inflow - Cash outflow

Not reported as income under GAAP

Reported in Statement of Cash Flows as net cash flow from operating activities


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Economic Income

Based on concept of “well-offness”

Economic Income is the maximum amount that can be distributed to owners during the accounting period and leave the business as well off at the end of the accounting period as it was at the beginning of the period


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Economic Income

  • A Capital maintenance concept of income

  • Income is the change in “value” of the net assets of the business during the accounting period

  • Measurements of assets and liabilities would be based on “fair value” at the balance sheet date, i.e., the present value of expected future cash flows


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Accounting IncomeAccrual Basis Income

  • Transactions based

  • The change in net assets is measured utilizing historical cost (with modifications)

  • A financial capital maintenance concept of income


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Accrual Basis IncomeCharacteristics

  • Revenue recognized when earned

  • Expenses matched with revenue

  • Based on historical cost

Income =

Revenue + Gains

- Expenses - Losses


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SFAC 1

  • Objectives Of Financial Reporting

    • To provide information

      • Useful in Investment & Credit Decisions

      • Useful in Assessing Cash Flow Prospects

      • About Enterprise Resources, Claims to Those Resources, & Changes in Them


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SFAC 1: Enterprise Performance & Earnings

  • The primary focus of financial reporting

  • Expectations about future performance are commonly based on past performance

  • Accrual based earnings provide a better indication of performance than cash flows

  • Relate Benefits and Costs of Operations, Events & Circumstances that affect the Enterprise


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Accrual Basis Accounting Income

  • Consistent with the concept of Financial Capital Maintenance

  • Income = the change in net assets occurring during the period excluding transactions with owners


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Chapter 6--Learning Objectives

2. Demonstrate the format of the income statement


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Income Statement

  • Includes the following elements of financial statements

    • Revenues

    • Expenses

    • Gains & Losses


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Income Statement Formats

  • Single Step

  • Multiple Step


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Single Step

Revenues & Gains

minus Expenses & Losses

Including Income Taxes


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Single-step income statement form

Revenues:

Sales revenue $XXX

Interest income XXX

Dividend revenue XXX

Gain on sale of equipment XXX

Other income XXX

Total revenue XXX


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Single-step income statement form

Expenses:

Cost of goods sold XXX

Selling & administrative expense XXX

Interest expense XXX

Loss on sale of land XXX

Other expense XXX

Provision for income taxes XXX

Total expenses XXX


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Multiple-step income statement form

Sales revenue $XXX

Cost of goods sold XXX

Gross profit XXX

Operating expenses:

Selling & administrative expense XXX

Other operating expenses XXX

Operating expenses XXX

Income from operations XXX


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Multiple-step income statement form

Other revenue and gains:

Interest revenue XXX

Gain on sale of equipment XXX

Other expenses and losses:

Loss on sale of land XXX

Other expenses XXX

Other revenue (expense) XXX

Income before taxes XXX

Provision for income taxes XXX

Net Income XXX


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Income statement form

  • Both single-step and multi-step formats are acceptable

  • APB Opinion No. 30 requires special presentation of:

    Discontinued operations

    Extraordinary items

    Cumulative effects of changes in accounting principles


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Elements of the income statement

Sales and operating revenues

Revenues from sales less discounts, returns and allowances

Cost of goods sold

Beginning inventory plus purchases (net of returns & allowances but including transportation) less ending inventory

Operating expenses

Normally classified as administrative expenses and selling expenses


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Elements of the income statement

Non-operating items

Revenues, expenses, gains and losses outside the normal operations of the business

Provision for income taxes

Includes federal, state and local income taxes

Special reporting items

Discontinued operations, extraordinary items and accounting changes


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Chapter 6--Learning Objectives

3. Specify which circumstances qualify as special reporting items, and explain how to measure and report those special items on the income statement


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Extraordinary ItemsAPB 30

Absent discontinued operations,

the following main captions should be reported in the income statement if extraordinary items are reported

Income before Extraordinary Item XXX

Extraordinary Item (less applicable taxes of $____) XXX

Net Income XXX


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Net sales XXX

CGS XXX

Gross profit XXX

Operating expenses XXX

Income from operations XXX

Other…(non operating items) XXX

Income before tax & extraordinary item XXX

Income tax XXX

Income before extraordinary item XXX

Extraordinary item (net of tax) XXX

Net income XXX


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Extraordinary Items? APB 30

  • Events and transactions that are distinguished by their unusualnature and infrequency of occurrence


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Unusual Nature

  • Abnormal

  • Significantly different from ordinary and typical activities of the entity

  • Beyond the control of management


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Unusual Nature

  • Primary consideration

    • The environment in which the entity operates

      • Characteristics of the industry

      • Geographical location

      • Extent of governmental regulation


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Infrequent

  • Not reasonably expected to recur in the foreseeable future

  • Take into account the environment in which the entity operates

  • Prior occurrence provides evidence to assess the probability of recurrence


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Extraordinary ItemsExamples

  • Results of a major casualty, e.g.,

    • Earthquake

  • Expropriation

  • Prohibition under a newly enacted law or regulation


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Items which are NEVER considered to be extraordinary

  • Write-downs of receivables and inventories

  • Foreign exchange gains and losses

  • Gains and losses from sale or abandonment of property, plant and equipment

  • Labor disturbances


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Accounting Change APB 20

  • Change in Accounting Principle

  • Change in Reporting Entity

  • Change in Estimate


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Change in Accounting Principle

  • Changing from one generally accepted accounting principle to another

  • Examples:

    • Change from LIFO to FIFO

    • Change from SYD Depreciation to Straight-line


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Change in Reporting Entity

  • When a company has investments in other entities over which it exercises significant influence or control

  • Change

    • how the investment is reported in the balance sheet and income statement

  • Example

    • Change from the equity method of accounting to consolidation


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Change in Estimate

  • Change in “good faith” estimate

  • Prompted by

    • Environmental changes

    • Availability of new information

  • Examples

    • Change in estimate of useful life of building

    • Change in fair value of investments in “trading securities”


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Accounting Treatments for Accounting Changes

  • Current

  • Retroactive

  • Prospective


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Current Treatment

  • Report Cumulative Effect in the Income Statement

  • Do not restate prior financial statements

  • Report Pro-forma Effects for

    • Income before extraordinary items

    • Net Income


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Cumulative effect in income statement

APB 30

Income from 0perations XXX

Other…(non operating items) XXX

Income before extraordinary item and

cumulative effect of accounting change XXX

Extraordinary item (less taxes of $____) XXX

Cumulative effect of accounting change (less taxes of $_____) XXX

Net income XXX


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When to apply Current Treatment

  • Changes in Principle

    • Exceptions are treated retroactively

  • Example

    • Change from Straight-line Depreciation to Double Declining Balance


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Retroactive Treatment

  • Report cumulative effect as an adjustment to the beginning balance of Retained Earnings

  • Restate prior financial statements

  • No need to report separate Pro-formas


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Retroactive treatment is required for

  • Changes from LIFO

  • Changes to or from full cost method in the extractive industry

  • Changes to the equity method of accounting for investments in stock

  • Changes in accounting for long-term contracts

  • Changes from retirement/replacement accounting to other depreciation methods

  • Changes associated with an IPO of stock


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Discontinued operations: APB: 30

Income from continuing operations

before tax XXX

Income tax expense XXX

Income from continuing operations XXX

Discontinued operations (less taxes) XXX

Extraordinary Items (less taxes)

Cum effect of accounting change (less taxes) XXX

Net income XXX


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Discontinued Operations: APB 30

  • Separately identifiable segment which is being disposed of

    • A major class of business

    • Separately identifiable assets, liabilities, revenues, and expenses


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Discontinued Operations In the Income Statement

  • Two components

    • Income (loss) from operations

    • Gain (loss) from disposal


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Discontinued Segment Income (Loss) from Operations

  • Disclosed when the decision to discontinue was made after the beginning of the year

  • Amount of income (loss) is determined from the beginning of the year to the date the decision is made to discontinue a segment’s operations (measurement date)


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Gain (loss) from disposal of segment assets

  • Gain (loss) during the phase-out period

  • Phase-out period can extend to subsequent accounting period


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The Possibilities

  • Measurement Date & Disposal Date occur in same accounting period

  • Measurement Date occurs in current period, Disposal Date occurs in a subsequent accounting period


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Measurement Date & Disposal Date in Same Period

Year End

Beginning of year

Measurement Date

Disposal Date

A

B

Phase Out Realized Gain (Loss)


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Disposal Date in Subsequent Period

Year End 2

Beginning of year

Measurement Date

Year End 1

Disposal Date

A

B

C

Realized Gain (Loss)

Estimated Gain (Loss)


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Disposal During a Subsequent Period - Special Rules

  • A realized Loss on disposal

    • Increase by estimated loss

    • Decrease by estimated gain (but only to zero)

  • A realized Gain on disposal

    • Decrease by estimated loss

    • Do not increase by estimated gain


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Chapter 6--Learning Objectives

4. Specify which circumstances qualify as prior-period adjustments, and explain how to measure, account for, and report those adjustments in the financial statements


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Prior period adjustments

  • SFAS No. 16 specifies three types:

    1. Corrections of errors

    2. Adjustments involving tax loss carryforwards of purchased subsidiaries

    3. Others specified by the FASB

  • Our focus is on the first type


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Prior period adjustmentsRequire Retroactive Treatment

  • Do not affect income in the year of discovery

  • Are NOT reported on the income statement

  • Adjustments are made directly to the Retained Earnings account

  • Adjustments are reported on the Retained Earnings statement


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Prepare the statement of retained earnings

Retained earnings, Jan. 1, 2000,

(as previously reported) $900,000

Correction of error in depreciation

expense not charged in prior periods

(net of $7,000 tax) ( 15,000)

Retained earnings, Jan. 1, 2000,

(restated) $885,000

Net income 110,000

Retained earnings, Dec 31, 2000 $995,000


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Chapter 6--Learning Objectives

5. Illustrate the computations and reporting requirements for earnings-per-share presentations

EPS


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EPS

  • What a share of common stock earned during the accounting period

  • Numerator = Income to Common Stockholders

    • Subtract preferred dividends

  • Denominator = Weighted average number of shares outstanding


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Must report EPS for

  • Income from Continuing Operations

  • Discontinued Operations

  • Extraordinary Items

  • Net Income


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Chapter 6--Learning Objectives

6. Understand corporate risk and profitability analysis, using the basic ratios and categories of ratios


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Profitability analysis

The most common measure is return on assets (ROA) calculated as follows:

Net income + [(Interest expense) x (1 - Tax rate)]

Average total assets


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Return on assets

  • Measures the return on the average capital invested in assets during the accounting period.

  • Since both lenders and stockholders provide capital, ROA includes income before interest and its associated tax benefit.


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Risk Analysis

  • ROA ignores the means by which operations are financed.

  • Also, investors are interested in the return to common stock

  • Hence, a frequent adjustment is to calculate the return on equity (ROE), sometimes called return on common equity (ROCE)


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Return on common equity

Return on assets

Less: Return to creditors

Less: Return to preferred shareholders

Equals: Return to common shareholders

or

Net income - preferred dividends

Average common equity


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