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The Income Statement and the Statement of Stockholders’ Equity. Chapter 11. Learning Objective 1. Analyze a complex income statement. Allied Electronics Corporation Income Statement Year Ended December 31, 20x5. Sales revenue $500,000 Cost of goods sold –240,000

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learning objective 1
Learning Objective 1

Analyze a complex income statement.

income statement continuing operations

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
income statement continuing operations4
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

income statement special items
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

income statement earnings per share
Income Statement - Earnings per Share

Earnings per share of common stock

(20,000 shares outstanding):

Income from continuous operations $2.70

Income from discontinued operations 1.05

Income before extraordinary item

and cumulative effect of change

in depreciation method $3.75

Extraordinary loss (0.60)

Cumulative effect of change in

depreciation method 0.30

Net income $3.45

continuing operations
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
continuing operations8
Continuing Operations
  • Investment capitalization rate – used to estimate the value of an investment in the capital stock of another company
continuing operations9
Continuing Operations

Assume an interest rate (i) of 12%

to valuate Allied.

Estimated value of Allied Electronics

common stock =

Estimated annual income in the future

÷

Investment capitalization rate

= $54,000 ÷ 0.12 = $450,000

continuing operations10
Continuing Operations

Current market

value of the

company

=

# of shares

of common stock

outstanding

×

Current

market price

per share

=

×

$513,000

$4.75

108,000

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

continuing operations investment decision
Continuing Operations:Investment Decision

Decision Rule:

Estimated value > market value? BUY

Estimated value = market value? HOLD

Estimated value < market value? SELL

In the Allied Electronics case:

Estimated

value of the

company

$450,000

<

Current

market

value

$513,000

Sell the stock

continuing operations investment decision12

=

Estimated annual earnings per share

÷

Investment capitalization rate

Continuing Operations:Investment Decision

Estimated value of

one share of common stock

irregular items
Irregular Items
  • Discontinued operations
  • Extraordinary items
  • Cumulative effect of a change in accounting principle
discontinued operations
Discontinued Operations
  • Segment – identifiable division of a company
extraordinary items
Extraordinary Items
  • Unusual for the company and infrequent
    • Losses due to natural disasters
    • Expropriations
  • Exception
    • Material gains/losses from extinguishment of debt (to be reported as extraordinary item)
cumulative effect of a change in accounting principle
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 share of common stock
Earnings per Shareof Common Stock

(Net Income – Preferred Dividends)

÷

Average Number of

Common Shares Outstanding

=

Earnings per Share

earnings per share of common stock18
Earnings per Shareof Common Stock
  • Requiredto be disclosed on the income statement for all major sections
  • Earnings per share issubject to dilution (reduction), if issue of additional shares is possible in the future
comprehensive income
Comprehensive Income
  • Change in total stockholders’ equity from all sources other than from owners of the business
  • Includes net income plus unrealized gains (losses) on available-for-sale investments and foreign-currency translation adjustments
statement of comprehensive income
Statement ofComprehensive Income

Net income $69,000

Other comprehensive income:

Unrealized gain on investment $ 6,500

Less income tax (40%) 2,600 3,900

Foreign-currency translation

adjustment (loss) $(9,000)

Less income tax (40%) 3,600 ( 5,400)

Comprehensive income $67,500

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

learning objective 2
Learning Objective 2

Account for a corporation’s income tax.

accounting for corporate income taxes
Accounting for CorporateIncome Taxes
  • Income tax expense – expense on income statement
  • Income tax payable – liability on balance sheet
accounting for corporate income taxes23

Income

tax

expense

=

Income before

income tax

(from the

income

statement)

×

Income

tax

rate

Income

tax

payable

=

Taxable

income (from

the incometax

return filed

with the IRS)

×

Income

tax

rate

Accounting for CorporateIncome Taxes

In general, income tax expense and income

tax payable can be computed as follows:

accounting for corporate income taxes24
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%.
accounting for corporate income taxes25
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

accounting for corporate income taxes26
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.

prior period adjustments
Prior-Period Adjustments
  • Corrections to the beginning balance of Retained Earnings for errors of an earlier period
reporting a prior period adjustment

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

restrictions on retained earnings
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
learning objective 3
Learning Objective 3

Analyze a statement of stockholders’ equity.

analyzing the statement of stockholder s equity
Analyzing the Statement of Stockholder’s Equity

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

learning objective 4
Learning Objective 4

Understand managers’ and auditors’ responsibilities for the financial statements.

responsibility for the financial statements
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
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 report36
Auditor Report
  • Unqualified (Clean)
  • Qualified
  • Adverse
  • Disclaimer