How Does a Write-Off Affect the Income Statement by Crizlap

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									  Chapter 13:

Income Statement

  Chapter 13: Income Statement
I. Financial statement relationships.
II. Income statement categories:
   1. operating revenues and expenses
   2. other revenues and expenses
   3. discontinued operations
   4. extraordinary items
III. Earnings per share
IV. Economic consequences associated with
   reporting net income.

      I. Relationships Among the
          Financial Statements
                   Statement of
                   Cash Flows

 Beginning           Income               Ending
Balance Sheet       Statement          Balance Sheet

                    Statement of
                (or Statement of SE)
    II. Elements of the Income Statement
   Comprehensive income - changes in net
    assets from all non-owner sources; is
    broken into two categories:
     – net income: consisting of revenues,
       expenses, gains and losses (next slide)
     – other comprehensive income:
       consisting of equity adjustments not
       reflected in the income statement.
       Examples include:
         unrealized gains and losses from
          revaluation of AFS investments.
         cumulative translation adjustment for
          foreign subsidiaries.
II. Elements of the Income Statement
   Revenues - increases in net assets for
    activities that constitute a company’s ongoing
    central operations.
   Expenses - decreases in net assets for
    activities that constitute a company’s ongoing
    central operations.
   Gains - increases in net assets for activities
    that constitute a company’s peripheral
   Losses - decreases in net assets for activities
    that constitute a company’s peripheral
   Note that account titles do not always match
    with activity (ex: interest revenue and interest
    expense are peripheral activity).
           II. Format of the I/S
See Page 565 for example of categories:
= Gross profit
- Operating expenses
= Income from operations
+ Other revenues and gains
- Other expenses and losses
= Income from continuing operations (IFCO)
+/-Discontinued operations
+/-Extraordinary items
= Net income
(Note: text also includes “Change in Accounting
Principles” but the FASB statement to eliminate this
category is expected to be issued in mid 2005.)
                II. Format of the I/S
   First, note the subtotals (=)
     – Gross profit is presented when a company uses
       a multi-step income statement; more relevant for
       companies that are primarily retail or
       manufacturing (less relevant for service
     – Income from operations indicates income from
       primary, on-going activity (usual and frequent).
     – Income from continuing operations (IFCO)
       also includes peripheral activity like interest
       income, as well as potentially nonrecurring
       activity like restructuring charges (unusual or
     – Net income also includes “special” items that are
       presented separately because they are
       significant activities that are usually nonrecurring.
                II. Format of the I/S
   Now, more information on the “special” items below
     – discontinued operations
     – extraordinary items
   Note that each of these items is presented “net of
    tax.” This is necessary because income tax
    expense has already been calculated on IFCO.
    Therefore, each level below IFCO must present the
    tax effect for that component.
   This is called “intraperiod” tax allocation -
    allocation of income tax expense to different parts
    of the income statement.
   A “partial” income statement is presented on the
    next slide (and assumes a 25% tax rate).
             II. Partial Income Statement-
                   Sample Company
               (assuming a 25% tax rate)
Income from continuing operations                   $120
Income tax expense                                   (30)
Income from continuing operations - net of tax        90
Discontinued operations
   Income from operations of discontinued segment
       (less tax effect of $25)                      75
   Loss on disposal of discontinued segment
       (less tax effect of $10)                      (30)
Extraordinary item
   Loss from flood damage
       (less tax effect of $9)                       (27)

Net income                                          $108
       II. Calculations - Sample Company
Note that “net of tax” can either be a gain/income
  offset by income tax expense, or a loss offset by an
  income tax reduction. In either case, the amount
  recognized is net, after the tax effect is subtracted
In Sample Company, the calculations are based on a
  25% income tax expense rate:
Note that the pretax amounts = the net amount + tax
Discontinued operations
  Pretax income of $100 x 25% = $25 expense
  Pretax loss of $40 x 25% = $10 expense reduction
Extraordinary (pretax) loss of $36 x 25% = $9 expense
    II. Format - Discontinued Operations
 Discontinued operations (DO) relate to the disposal of
  a segment of a company. Because the disposal
  means that the segment activity will be discontinued,
  separate disclosures are required so that investors
  could distinguish between ongoing activity and
  nonrecurring activity.
 A segment is defined as an entire line of business or a
  separately identifiable segment. For example, General
  Motors would need to discontinue Chevrolet (not just a
  manufacturing plant).
 Financial statement presentation includes any
  operating income or loss to the measurement date (the
  date the board of directors declares intention to
  dispose of the segment), as well as any gain or loss on
  the disposal of the assets.

II. Problems with Discontinued Op.
 Does not require a sales contract to
  reclassify to discontinued operations.
 IFCO can be manipulated with the
  declaration (and reclassification) of the
  discontinued segment.

      II. Format - Extraordinary Items
 Extraordinary items are defined as those activities that
  are material in amount, unusual in nature, and
  infrequent in occurrence.
 To determine, consider the natural, political, and
  economic environment of the firm.
 Examples of EI include natural disasters,
  nationalization or expropriation of assets by a foreign
  government, and one-time major economic
 If unusual or infrequent, but not both, report in “other
  gains/losses”, as part of IFCO. Examples include
  material write-down of receivables, and loss from
  employee strike.

  I/S Classification - Class Problem
1.Loss in Florida from hurricane:
  Other expenses and losses
2.Loss from sale of a segment:
  Discontinued operations
3.Loss from terrorist activity:
  Extraordinary item
4.Material write-off of accounts receivable:
  Other expenses and losses
5.Normal write-off of accounts receivable:
  No effect on the income statement
6.Loss from flood (in a 500-year flood plain):
  Extraordinary item
     II. I/S Format - Other Issues
 Consistency requires the use of the same
  accounting method from year to year.
 However, a company may choose to
  change to an alternative accounting method
  (ex: DDB to SL or FIFO to average).
 Also, a company may be required to
  change to a new accounting technique by
  the issue of a new accounting standard.
 The APB required companies to show the
  cumulative effect for prior years’ income
  on the current income statement in a
  special category called “change in
  accounting principle.”
         II. I/S Format - Other Issues
   This special category allowed investors to
    analyze IFCO for the current year separately
    from the effect of the cumulative change.
   Problem: This “cumulative” calculation was
    reported as part of current net income, even
    though it relates to prior years’ net income.
   Solution: FASB will recently (in mid 2005)
    eliminate this category from the income
    statement. Then all changes in principle will
    receive either a retroactive restatement (like
    errors of a prior period) or a prospective
    treatment (like changes in estimate).
         III. Earnings Per Share (EPS)
   SFAS 128 simplified the presentation of earnings
    per share to two components:
    – basic EPS
    – diluted EPS
   Calculation of Basic EPS =
           Net Income - preferred dividends
       Average common shares outstanding
   Concept: To indicate how much each common
    shareholder “owns” with respect to earnings.
   Preferred dividends are deducted - if declared or if
    cumulative - because they are “owned” by to
    preferred shareholders.
   This is a calculation of “what is” - the numerator
    and denominator use actual shares outstanding
    and actual net income for the year.                 17
         III. Earnings Per Share (EPS)
 Diluted earnings per share examines all the
  potentially dilutive securities that a company has
  issued, like convertible preferred stock, convertible
  bonds, and employee stock options. Although these
  securities have not been converted at year end, the
  calculation shows the effect that the shares could
  have on EPS.
 Calculation of Diluted EPS =
    Net Income - P.D. + adjustment for dilutive shares
    Avg. CS outstanding + adjustment for dilutive shares
   Concept: To indicate how much each common
    shareholder would “own” with respect to earnings IF
    all dilutive securities had been exercised at the
    beginning of the year.

            III. Earnings Per Share (EPS)
   Diluted EPS is a “what if” calculation - the numerator
    and denominator are adjusted for potential effects of
    dilutive securities as of the securities had been
    converted to common stock at the beginning of the
    current year:
    – convertible PS:
           eliminate preferred dividend (would not exist if converted)
           increase shares outstanding (would be larger if converted)
    – convertible bonds:
           eliminate interest expense (would not exist if converted)
           increase shares outstanding (would be larger if converted)
    – stock options:
           no numerator effect (generally speaking)
           increase shares outstanding (note that it is not a 1 for 1
   If any of these potentially dilutive securities exist, the
    company is said to have a complex capital structure.
        III. Earnings Per Share (EPS)
Class problem:
Bush Company reported net income of $30,000 in
2005. The company had 60,000 shares of common
stock outstanding for all of 2005. Bush also had
5,000 shares of convertible preferred stock
outstanding for all of 2000. During 2005, the
company declared a $4,000 cash dividend to
preferred shareholders. Each share of preferred
stock is convertible to 4 shares of common stock.
1.Calculate basic EPS:
        $30,000 - 4,000 = $0.43 per share
  (Note that the convertibility component is ignored for
   basic EPS.)
       III. Earnings Per Share (EPS)
2. Calculate diluted EPS:
      $30,000 - 0 _ = $0.38 per share
   60,000 + (5,000 x 4)

Note that the convertibility component is assumed to
 have been exercised for diluted EPS. If the PS
 was converted to CS at the beginning of the year,
 there would have been NO preferred dividend,
 and there would have been 20,000 additional
 shares of common stock outstanding all year.

The effects for convertible bonds and employee
  stock options are similar for diluted EPS.
              III. EPS Disclosure
   Separate EPS disclosure for:
     – Net income from continuing operations (after
     – Disposals of business segments
     – Extraordinary items
   Calculation
     – Separate dollar amount (from above
        categories) divided by number of common
        shares outstanding
   If diluted EPS exists, the company should also
    calculate diluted EPS for each level of
   If diluted EPS is antidilutive (the calculation is
    actually higher than basic EPS), the company
    does not have to present diluted EPS.
III. EPS Disclosure - Sample Co.
      (Based on 100,000 shares outstanding.)

Basic Earnings Per Share:
  Income from continuing operations     $0.90
  Discontinued operations
      Income from operations of segment 0.75
      Loss on disposal                  (0.30)
  Extraordinary loss                    (0.27)
  Net income                               $1.08

           III. Problems with EPS
   The numerator can be manipulated by a
  number of earning management techniques.
 The denominator can be manipulated by stock
  buybacks (treasury stock).
 The “what-if” presentation of diluted EPS is a
  fictitious number - it can never actually
  happen. The potentially dilutive securities
  have not been converted at year end, and they
  can never have claims to the current year’s
  income. The only benefit of diluted EPS is
  that it can indicate the magnitude of the
  maximum potential dilution for the future.

       IV. Economic Consequences of
            Reporting Net Income
   Investors focus heavily on income and related
    indices like earnings per share and the P/E (price
    per share to earnings per share) ratio.
   Recent announcements (noting that the reported
    EPS was off the estimate by as little as a penny)
    have caused the market price of reporting
    companies to drop significantly.
   Because of investor focus, and because of
    compensation bonuses, managers continue to
    focus heavily on the bottom line, sometimes with
    dire effects.
   Expanded financial statement disclosure, and
    increased awareness by investors, may stem this
    earnings fixation.

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