Chapter 4

1. Chapter 4 The Income Statement and Statement of Cash Flows

2. Comprehensive Income Proponents argue that certain changes in equity should be included in the determination of net income.

3. Comprehensive Income Statement of Financial Accounting Standards No. 130 Comprehensive income includes traditional net income and changes in equity from nonowner transactions. • Examples of nonowner transactions: • Foreign currency translation adjustment, net of tax • Unrealized gains(losses) on investment securities, net of tax • Minimum pension liability adjustment, net of tax

4. Income from Continuing Operations Revenues Inflows of resources resulting from providing goods or services to customers. Expenses Outflows of resources incurred in generating revenues. Gains and Losses Increases or decreases in equity from peripheral or incidental transactions of an entity. Income Tax Expense Because of its importance and size, income tax expense is a separate item.

5. Income Statement Operating Income Nonoperating Income vs.

6. { Proper Heading Revenues & Gains { { Expenses & Losses Income Statement (Single-Step)

7. { Proper Heading { Gross Margin { Operating Expenses { Non- operating Items Income Statement (Multiple-Step)

8. 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.

9. Manipulating Income and Income Smoothing “Most managers prefer to report earnings that follow a smooth, regular, upward path.” • Two ways to manipulate income: • Income shifting • Income statement classification

10. Separately Reported Items Three types of events are reported separately, net of taxes: 1. 2. 3.

11. Intraperiod Income Tax Allocation Income Tax Expense must be associated with each component of income that causes it. Show Income Tax Expense related to Income from Continuing Operations. Report effects of Discontinued Operations, Extraordinary Items, and Cumulative Effect of Accounting Changes NET OF INCOME TAXES.

12. Discontinued Operations • Sale or disposal of a component of an entity. • A component includes: • Reportable segments • Operating segments • Reporting units • Subsidiaries • Asset groups

13. Discontinued Operations • 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.

14. Discontinued Operations • Results of operations include two items: • The income or loss stream for the period from the identifiable discontinued operation. • The actual gain or loss from disposal of the component or an “impairment loss” if the component is held for resale.

15. Carrying Value of Assets < (Fair Value of Assets - Cost to Sell) Discontinued Operations • Results of operations include two items: • The income or loss stream for the period from the identifiable discontinued operation. • The actual gain or loss from disposal of the component or an “impairment loss” if the component is held for resale.

16. Discontinued Operations Example 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 on the income statement?

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

18. Discontinued Operations Example Income Statement Presentation:

19. Extraordinary Items • Material in amount • Gains or losses that are • unusual in nature and • infrequent in occurrence. • required by GAAP. • Reported net of related taxes

20. Extraordinary Items Example 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 on the income statement?

21. Extraordinary Items Example Income Statement Presentation:

22. 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.

23. Accounting Changes

24. Change in Accounting Principle • Occurs when • Changing from one GAAP method to another GAAP method, or • Changing the method of application of an existing principle. • Make a catch-up adjustment known as the cumulative effect of a change in accounting principle. • The cumulative effect is reported net of taxes and after extraordinary items.

25. Change in Accounting Principle Example During the year, Apex Co. decided to change from the double-declining balance to the straight-line method for depreciation. The effect of this change is an increase in net income of $65,000. Apex reported income of $128,387 during the year. All items of income are subject to a 30% tax rate. How would this item appear on the income statement?

26. Computation: Income Statement Presentation: Change in Accounting Principle Example

27. Change in Estimates • Revision of a previous accounting estimate. • The new estimate should be used in the current and future periods. • The prior accounting results should not be be restated.

28. Change in EstimatesExample On January 1, 2000, we purchased equipment costing $30,000, with a useful life of 10 years and no salvage value. During 2003, we determine that the remaining useful is 5 years (8-year total life). We use straight-line depreciation. Compute the revised depreciation expense for 2003.

29. Change in EstimatesExample Record depreciation expense of $4,200 for 2003 and subsequent years.

30. Change in Reporting Entity Financial statements are prepared for separate entities.

31. Change in Reporting Entity If two entities combine, a single set of consolidated financial statements is generally required.

32. Change in Reporting Entity • If two entities combine: • Prepare a single set of consolidated financial statements. • Retroactively restate financial statements of prior periods.

33. Prior Period Adjustments • Corrections of errors from a previous period. • Appear on the Statement of Retained Earningsas an adjustment to beginning retained earnings. • Must show the adjustment net of income taxes.

34. Prior Period Adjustments Example While reviewing the depreciation entries for 2001-2004, the controller found that in 2003 depreciation expense was incorrectly debited for $150,000 when in fact it should have been debited $125,000. All items are taxed at 30%. Prepare the necessary journal entry in 2004 to correct this prior period error.

35. Prior Period Adjustments Example If this was the original entry, how do we correct it? Can we just reverse it? Why or why not?

36. To correct the 2003 error in 2004, we can debit Accumulated Depreciation since it is a permanent account. Prior Period Adjustments Example

37. Prior Period Adjustments Example We can’t credit Depreciation Expense since it was closed in 2003, so we credit Retained Earnings.

38. Prior Period Adjustments Example Remember to consider the tax effects: $25,000 × 30% = $7,500 taxes payable

39. Basic Earnings Per Share

40. Earnings Per Share Disclosure • Report EPS data separately for: • Income from Continuing Operations • Discontinued Operations • Extraordinary Items • Cumulative Effect of a Change in Accounting Principle • Net Income

41. Statement of Cash Flows • Provides relevant information about a company’s inflows and outflows of cash. • Helps investors and creditors to assess • future net cash flows • liquidity • long-term solvency.

42. + _ Cash Flows from Operating Activities Inflowsfrom: • Sales to customers. • Interest and dividends received. Cash Flows from Operating Activities Outflowsto: • Purchase of goods for resale and services. • Salaries and wages. • Interest on debt. • Income taxes.

43. Direct Method Indirect Method Reports the cash effects of each operating activity Starts with accrual net income and converts to cash basis Direct and Indirect Methods of Reporting Two Formats for Reporting Operating Activities

44. Inflowsfrom: Sale of property, plant, and equipment. Sale or maturity of investment securities (stocks and bonds). Collection of nontrade receivables. + _ Cash Flows from Investing Activities Cash Flows from Investing Activities Outflowsto: • Purchase of property, plant, and equipment. • Purchase of investment securities (stocks and bonds). • Loans to other entities.

45. Inflowsfrom: Borrowing on notes, mortgages, bonds, etc. from creditors. Issuing stock to owners. + _ Cash Flows from Financing Activities Cash Flows from Financing Activities Outflowsto: • Repay principal to creditors (excluding interest). • Repurchase stock from owners. • Dividends to owners.

46. End of Chapter 4