Learning Objectives • Define the concept of income. • Explain why an income measure is important. • Explain how income is measured, including the revenue recognition and expense-matching concepts. • Understand the format of an income statement.
Learning Objectives • Describe the specific components of an income statement. • Describe the specific components of an income statement. • Compute comprehensive income and prepare the statement of stockholders’ equity. • Construct simple forecasts of income for future periods.
Capital Maintenance • Income per financial capital maintenance: • Results only if ending balance of owners’ equity (in monetary units) is greater than beginning balance (in monetary units). • When trading a specific item, income equals difference of historical cost and net realizable value.
Capital Maintenance End of Period Beginning of Period Total assets $510,000 $560,000 Total liabilities 430,000390,000 Net assets (owners’ equity) $ 80,000 $170,000 Income is $90,000 Kreidler, Inc., had the following assets and liabilities at the beginning and at the end of a period.
Capital Maintenance If the owners invested $40,000 in the business and received dividends of $15,000, what would be the income? Net assets, end of period $170,000 Net assets, beginning of period 80,000 Increase in net assets $ 90,000 Deduct investment by owners (40,000) Add dividends to owners 15,000 Income $ 65,000
Capital Maintenance • Income per physical capital maintenance: • Results only if production capacity at the end of the period exceeds capacity at the beginning of the period. • Capacity is measured by replacement cost of net assets. • Income/loss is the difference between replacement cost and net realizable valuable. • Difference between historical cost and replacement cost is considered a capital maintenance adjustment and not part of income.
Example of Capital Maintenance • Assume purchase of a house: • Purchase price $ 50,000 • Replacement cost (Year 5) 150,000 • Sale price (Year 5) 175,000 • Calculate income under financial capital maintenance and under physical capital maintenance assumptions.
Financial Capital Maintenance Income (difference of beginning equity and ending equity) $125,000 Assets Liabilities Equity Date 1/1/X0 1/1/X5 $ 50,000 $175,000 -0- -0- $ 50,000 $175,000
Physical Capital Maintenance Assets Liabilities Equity Date 1/1/X0 1/1/X5 $ 50,000 $175,000 -0- -0- $ 50,000 $ 175,000 Change in owners’ equity Change necessary to allow for replacement of home ($150,000 - $50,000) Income $ 125,000 100,000 $ 25,000
Why Is a Measure of Income Important? The recognition, measurement, and reporting of business income and its components are considered by many to be the most important tasks of accountants.
Why Is a Measure of Income Important? Will the company be profitable enough to pay interest on its debt and dividends to it stockholders and still grow at the desired rate? What is the trend of profitability? What is the most probable result for future years? Has the activity been profitable?
How Is Income Measured? Income is measured as the difference between resources inflows (revenues and gains) and outflows (expenses and losses) over a period of time.
Elements of Income • Revenue: Inflows or other enhancements of assets of an entity or settlements of its liabilities from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing, major or central operations (SFAC 6.78).
Elements of Income • Expense:Outflows or other “using up” of assets or incurrence of liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations (SFAC 6.80).
Elements of Income • Gain:Increase in equity from peripheral or incidental transactions of an entity and from all other transactions . . . except those that result from revenues or investments by owners (SFAC 6.82).
Elements of Income • Loss: Decrease in equity from peripheral or incidental transactions of an entity and from all other transactions . . . except those that result from expenses or distributions to owners (SFAC 6.83).
Elements of Income • Recognition: The process of formally recording or incorporating an item in the financial statements of an entity (SFAC 6.143). • Realization: The process of converting noncash resources and rights into money refers to sales of assets for cash or claims to cash.
Elements of Income Revenues are recognized when the company generating the revenue has provided the bulk of the goods or services it promised for the customer and when the customer has provided payment or least a valid promise of payment.
Recognition Criteria:Expenses and Losses (SFAC 5.86) • Direct matching. • Systematic and rational allocation. • Immediate recognition.
Recognition Criteria:Expenses and Losses (SFAC 5.86) • Direct Matching: Expenses are recognized upon recognition of revenues that result directly and jointly from the same transaction or other events as the expenses. Direct expenses include not only those that have already been incurred but should also include anticipated expenses related to revenues of the current period.
Recognition Criteria:Expenses and Losses (SFAC 5.86) • Systematic and RationalAllocation:Costs are allocated by systematic and rational procedures to periods during which the related assets are expected to provide benefits (i.e., depreciation). This category involves assets that benefit more than one accounting period.
Recognition Criteria:Expenses and Losses (SFAC 5.86) • Immediate Recognition: Expenses are recognized during the period in which cash is spent or liabilities are incurred for goods and services (i.e., selling and administrative salaries). This category involves expenses for goods and services that are used almost immediately.
Form of the Income Statement GAAP requires certain income statement disclosures. Right, but GAAP does not require a specific format.
Form of the Income Statement Revenue $xxx Costs and expenses: Costs of sales $xxx Selling and administrative xxx Interest expense xxx Other income/expense, net xxx Restructuring charge xxx Total costs and expenses $xxx Income before income taxes $ xx Income taxes xx Net income $ xx Single-Step Income Statement
Form of the Income Statement Revenue $xxx Costs of goods sold: Beginning inventory $xxx Net purchases xxx Cost of goods available for sale $xxx Less ending inventory xxxxxx Gross profit on sales $xxx Operating expenses: Selling expenses $xxx General expenses xxxxxx Operating income $xxx Multiple-Step Income Statement Continued on next slide
Form of the Income Statement Other revenue and gains $xxx Other expenses and losses (xxx) Income from continuing operations before income taxes $xxx Income taxes on continuing operations (xxx) Discontinued operations: Loss from operations of discontinued business segment (net of tax) $xxx Loss on disposal of segment (net of tax) xxx (xxx) Extraordinary gain (net of tax) xxx Net income $xxx
“Below the Line” Items • GAAP requires certain items be reported “below the line” and net of tax. • “Below the line,” or following Income from Continuing Operations. • Net of tax requires the tax effect of the event be shown.
“Below the Line” Items • Discontinued Operations • Extraordinary Items • Changes in Accounting Principles
Discontinued Operations--Phases Operating Loss (net of tax) $24,500 Loss on Disposal (net of tax; includes operating results 7/1 through 11/17 and loss on final disposal) $11,200 1/1/02 7/1/02 11/17/02 12/31/02 Statement Date Phase-out Period Disposal Date Measurement Date
Discontinued Operations--Disclosure • Income statement section consists of two parts: • Income (loss) from operations--disclosed only if decision to discontinue operations is made after beginning of the year. • Gain (loss) on disposal of operations-- consisting of income (loss) during phase- out and gain (loss) from disposal of segment assets.
Discontinued Operations--Disposal Date After Year End Statement Date Measurement Date Disposal Date Loss on Disposal $5,000 (including $2,000 expected operating loss) Phase-out Period 12/31/02 8/31/01 4/29/02 Operating Loss $4,000 8/26/01
Discontinued Operations--Disposal Date After Year End • Special rules when disposal date is in year following measurement date. • A realized “loss on disposal” may be increased by an estimated loss or it may be reduced by an estimated gain. • A realized “gain on disposal” may be reduced by an estimated loss but cannot be increased by an estimated gain.
Extraordinary Items--Characteristics Extraordinary items must be both unusual and infrequent...
Extraordinary Items--Characteristics …and material, or extraordinary by definition.
Extraordinary by Definition • Gain or loss from extinguishment of debt. • Application of tax carry-forward when tax benefits are not recognized until realized in subsequent period. • If in prior years an item is reported as (1) disposal of business segment, or (2) as an extraordinary item, the effect of a reversal is disclosed in the same manner. • Unamortized costs of interstate operating rights.
NEVER Extraordinary • Write-down or write-off of receivables, inventory, etc. • Translation of foreign exchange or devaluation. • Disposal of business segment. • Sale of productive assets. • Effects of a strike. • Adjustment of accruals on long-term contracts.
Changes inAccounting Principle • Report after Extraordinary Items. • Criteria for change: change only if the new principle is preferable: • provides more useful information. • is less costly per benefit.
Changes in Accounting Principle--Disclosure Requirements • Report current year’s income components on the new basis. • Report the cumulative effect of the adjustment in the current income statement--direct effect only; net of tax. • Present prior period financial statements as previously reported. • Include pro forma information as if the change were retroactive--direct and indirect effects. • Present earnings per share data for all prior periods presented.
Change of Estimates • Employ current and prospective approach. • Report current and future financial statements on new basis. • Present prior periods as previously reported. • Make no adjustments to current period opening balances. • Present no pro forma data.
Change of Principle andChange of Estimate If there is both a change in principle and a change in estimate for an item, the event is treated as a change in estimate.
Return on Sales 1998 1997 1996 AT&T 12.1% 8.6% 11.4% McDonald’s 12.5% 14.4% 14.7% IBM 7.8% 7.8% 7.2% Nike 4.2% 8.7% 8.6%
Comprehensive Income Comprehensive income is the amount that reflects the change in a company’s wealth during the period. In addition to net income, it includes items that, in general, arise from changes in market conditions unrelated to the business operations of a company.
Comprehensive Income The more common adjustments made in arriving at comprehensive income are: • Foreign currency translation adjustments. • Unrealized gains and losses on available-for-sale securities. • Deferred gains and losses on derivative financial instruments.
Comprehensive Income Most companies include a report of comprehensive income as part of the statement of stockholders’ equity.
Earnings, Net Income, and Comprehensive Income Revenue Expenses Operating Income Gains Losses Earnings Cumulative Accounting Adjustment Net Income Unrecognized Holding Gains Unrecognized Foreign Exchange Changes Comprehensive Income $100 80 $ 20 3 (8) $ 15 (2) $ 13 2 1 $ 16