STATEMENTS OF INCOME AND RETAINED EARNINGS A. Role of the Income Statement (Statement of Earnings) 1. Measure of overall economic performance of the enterprise 2. Measure of relative efficiency of operations 3. Measure of current and future cash flows that will result from a period's operations 4. Information about the probable timing of cash flows 5. Information about the risk levels of cash flows B. Limitations of Statements of Earnings 1. Changes in the value of some resources are not reported in statements of earnings based on historical-costs. 2. Changes in the value of the measuring unit--the dollar-- are not considered in statements of earnings based on historical costs. 3. The selection of generally accepted accounting methods can affect the level of earnings reported. This difference is due entirely to the choice of accounting methods. 4. The "quality" of reported earnings may vary. a. Length of "useful lives" used for depreciation purposes b. Use of straight-line vs. accelerated depreciation methods c. Number of periods used to amortize the cost of intangible assets d. Conservatism reflected in estimates of future expenses, reductions in revenue, and gains or losses. e. Revenue recognition criteria in use. C. Reporting Format Options 1. Single-step or multiple-step statements 2. Condensed or more detailed financial statements 3. Comparative or single period disclosure. D. Major Sections of Statements of Earnings 1. Operating section a. sales or revenue b. cost of goods sold c. selling expenses d. administrative or general expenses 2. Nonoperating (but continuing) section a. Other revenues and gains, generally net of related expenses from nonoperating activities. b. Other expenses and losses, generally net of any related incomes, from nonoperating transactions. c. Sometimes several unusual items that are not properly classified as extraordinary items are reported in a separate section titled "Unusual Items" after items form continuing operations and before extraordinary items and the reporting of income taxes on continuing operations. 3. Income taxes levied on income from continuing operations 4. Discontinued operations a. Shown net of tax b. Disposal of a segment of a business constituting a separate line of business or a class of customers c. Does not include: (1) Disposal of part of a line of business (2) Shifting production or marketing activities for a particular line of business from one location to another (3) Phasing out a product line or class of service (4) Other changes associated with technological improvement d. Note that many restructurings are not considered to be discontinuances of operations. 5. Extraordinary items - unusual and infrequent material gains and losses. a. Unusual nature:--The underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to the ordinary and typical activities of the entity, taking into account the environment in which the entity operates. b. Infrequency of Occurrence:--The underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates. c. Material as evaluated on an item-by-item basis. d. Explicitly excludes: (1) Writedown or writeoff of receivables, inventories, equipment leased to others, deferred research and development costs, or other intangible assets. (2) Gains or losses from exchange or translation of foreign currencies, including those relating to major devaluations and revaluations. (3) Gains or losses on the disposal of a segment of a business. (4) Other gains or losses from the sale or abandonment of property, plant, or equipment used in the business. (5) Effects of a strike, including those against competitors and major suppliers. (6) Adjustment of accruals on long-term contracts. e. Explicitly includes:--Material gains and losses from the extinguishment of debt. 6. Cumulative effect of a change in accounting principle a. Cumulative effect, net of tax, based on a retroactive computation of changing to a new accounting principle b. The effect of the change on the current year's operations should be incorporated into the revenues and expenses of the period based on the principle adopted. 7. Net Income or Net earnings 8. Earnings per share information a. Net income per share b. Income from continuing operations per share c. Income before extraordinary items and cumulative effect of changes in accounting principles per share d. Cumulative effect of changes in accounting principles per share E. Accounting Changes: Estimates, Principles or Errors 1. Estimates significantly influence the level of net income earned during any accounting period. Changes and updates in most estimates are deemed to affect current and future periods, not prior periods. Examples include changes in the realizability of receivables and inventories; changes in the estimated economic lives of plant and equipment, and intangible assets; and changes in estimated warranty costs, income taxes and employee benefits. Estimates are constantly being revised and updated based on changing economic conditions and new information. 2. Accounting Principles may be changed voluntarily by a company to more accurately reflect its operating performance--or the change may be involuntary. The company's independent accountant may require a change to meet the auditor's judgment about adequate disclosure in accordance with generally accepted accounting standards (GAAP). The Securities Exchange Commission (SEC) may require the change, or the change may be required to implement a new accounting standard promulgated by the Financial Accounting Standards Board (FASB). 3. Accounting Errors occur for a variety of different reasons, including inadequate investment by management in good systems that are operated by well-trained people. Errors made in an accounting period are normally discovered and corrected within the same accounting year. Year-end accounting review procedures and the subsequent independent audit are designed to locate and correct errors prior to the finalization and distribution of the annual financial statements. However, errors of one period may go undetected until a later period. Since financial statements cannot be "recalled for correction," correction of prior period income are made to the beginning balance of Retained Earnings in the Statement of Retained Earnings or Combined Statement of Earnings and Retained Earnings.
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