Limitations of Financial Statements Income Statement - DOC by zqh15621

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									Chapter 4                                                                       Page 1 of 14


Chapter 4: Income Statement and Related Information


(REMEMBER: ALWAYS put headings on your financial statements, especially during the
EXAMS. Points are subtracted if the financial state ments do not list the company name,
financial statement, date/time period. Also, ALWAYS date your journal entries.)



The purpose of this chapter is to examine the different types of revenues, expenses, gains, and
losses that affect the income statement and related information.

1) Income State ment: Report that measures the success of enterprise operations for a given
   period of time. Provides investors and creditors with info that helps them predict the
   amounts, timing, and uncertainty of future cash flows. (Objective #2 in our Basic Objectives
   from Chapters 1 and 2.)
   a Usefulness of the Income Statement: Income information is useful for:
       i)

       ii)


       iii) Information about the various components of income – revenues, expenses, gains, and
            losses – is helpful for assessing the likelihood that particular cash flows will continue
            in the future.

   b   Limitations of the Income State ment: Net Income is an _________________ that
       reflects assumptions made. Users should be aware of its limitations.
       i) Items that cannot be measured reliably are not reported in the income statement. For
           example:
           (1)


              (2)


       ii)


       iii)


   c   Quality of Earnings : If managers are focused on meeting financial targets, such as
       analysts’ forecasts to the detriment of good business practices, the quality of earnings and
       the quality of financial reporting will erode.
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       Earnings management:



       It has a negative effect on earnings quality if it distorts the information that makes the
       current year (1) misrepresentative of a company’s true state and (2) less useful for
       predicting future earnings and cash flow.

2) Format of the Income State ment:
   Transaction approach: focuses on the income-related activities that have occurred during
   the period. That is, net income results from revenue, expense, gain, and loss transactions.
   (Capital maintenance approach is the most common alternative. Here, income for the
   period is determined based on change in equity, after adjusting for investments by owners or
   dividends. However, the components of income are not evident in the capital maintenance
   approach.)

   a   Ele ments of the Income State ment:
       i) Revenues:



       ii) Expenses:



       iii) Gains:



       iv) Losses:



       v) Gains and Losses:

            Some examples:


   b   Single-Step Income Statement: LN: Aggregate Data.
       i) Just two groupings exist: _________________________________________

            The single step is subtracting ______________________________________.
            Sometimes income tax is reported as the last item before net income (to show its
            relationship to income before income tax.) Example on page 130.
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       ii) Example Format:
           SINGLE STEP FORM:
                                     Company Name
                                     Income Statement
                                     For the Year Ended 12/31/xx
            Revenues and Gains:
               Net Sales                                                  xx
               Other Revenue (e.g., Interest, Dividend revenue, Rent)     xx



                       Total Revenues and Gains:                          xx
            Expenses and Losses:
               Cost of goods sold                                         xx
               Selling expenses                                           xx
               General and Administrative expenses                        xx
               Depreciation expense                                       xx
               Interest expense                                           xx




                       Total Expense and Losses                            xx
            Income from Continuing Operations                              xx
            THE REST OF THIS INCOME STATEMENT FOLLOWS THE SAME
            APPROACH AS THE MULTI-STEP INCOME STATEMENT.
       iii) Primary Advantage of Single Step IS: The presentation is simple and no
            implication exists about the importance of any one type of revenue or expense item.

   c   Multiple-Step Income Statement: example on page 132.
       i) Further Classifications Included:
          (1) Separate operating and non-operating company activities presented. For example,
              “Income from Operations” is presented and then “Other Revenues and Gains” and
              “Other Expenses and Losses” are presented.
          (2) Expenses are classified by functions (e.g., COGS, selling, and administration.)

       ii) Relationships Recognized:
           (1) Recognizes Operating transactions separately from non-operating transactions.
           (2) Matches Costs and expenses with related revenue.
           (3) Highlights intermediate components of income useful for computation of ratios
               used to assess enterprise performance.
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      iii) Inte rmediate Components of the Income State ment:
           (1) Possible Sections/Subsections of Multi-Step Income State ment (page 129)
               (a) Operating Section:
                   (i) Sales or Revenue Section: Includes sales, discounts, allowances, returns,
                        and other related info.
                   (ii) Cost of Goods Sold Section.
                   (iii)Selling Expenses.
                   (iv) Administrative or General Expenses.
               (b) Non-operating Section.
                   (i) Other Revenues and Gains.
                   (ii) Other Expenses and Losses.
               (c) Income Tax.




               (d) Discontinued Operations.
               (e) Extraordinary Items.
               (f) Earnings Per Share.

            (2) To arrive at net income on the multi-step income statement, three subtotals are
                presented:
                (a)

               (b)

               (c)

                     Disclosing income from operations highlights the difference between regular
                     and irregular or incidental activities. Irregular or incidental revenues are
                     disclosed elsewhere in the income statement.
Chapter 4                                                                                          Page 5 of 14


      iv) Example Format: MULTI-S TEP FORM: (Be able to do this on your own.)
                                              Company Name
                                              Income Statement
                                              For the Year Ended 12/31/xx
            Sales Revenue




            Cost of Goods Sold




            Operating Expenses
                Selling expenses
                          Sales salaries and commissions
                          Advertising expense
                          Postage and stationery
                          Telephone and Internet expense



                General and Administrative expenses
                          Officers’ salaries
                          Office salaries
                          Depreciation expense
                          M iscellaneous office expenses

            Income from operations

            Other Revenues and Gains
                Rental Revenue



            Other Expenses and Losses


            Income from continuing operations before income tax
                Income tax
            Income from continuing operations
            Discontinued Operations

            Income before extraordinary items
            of accounting change
            Extraordinary items
            Net Income
            Earnings per common share
            Note: You will not always have all of these sections. For example, if there are no DE items (discontinued ops,
            extraordinary items), after other expenses and losses, you would have Income before income tax, income tax, net
            income. Also, the phrase “Income from continuing operating” is used only when gains or losses on
            discontinued operations occurs. Otherwise, “Income from Operations”.
Chapter 4                                                                      Page 6 of 14


   d     Condensed Income Statements:
         Include only the totals of expense groups in the income statement and prepare
         supplementary schedules to support the total. Page 133 shows a condensed version of the
         more detailed multiple-step statement presented on page 132. The condensed version is
         more commonly found in practice. (Notice the reference to “see Note D” in Illustration
         4-3 on page 133. This refers to the supporting schedule for selling expenses shown in
         Illustration 4-4 on page 134.)

         Knowing how much detail to include in the Income Statement always presents a problem.
         We want simple, summarized statements that lead readers to important factors. However,
         we want to disclose results of all activities. Certain basic elements are always included
         but they can be presented in various formants.




3) Reporting Irregular Items : Income measurement follows an all- inclusive approach. In
   other words, most items, even irregular ones, are recorded in income. Prior period
   adjustments (i.e., errors in prior years’ income measurement) are NOT included in income.
   Because these items have affected earnings already reported in a prior period, they are not
   included in current income but recorded as adjustments to retained earnings.

   The accounting profession currently uses a modified all- inclusive concept and requires
   application of this approach in practice. Irregular items are required to be highlighted so that
   the reader of financial statements can better determine the long-run earnings power of the
   enterprise. The items fall into six general categories (p136):
   Above the Line:
   (1)

   (2)

   (3)

   (4)

   Below the Line:
   (5)

   (6)

   Where “Line” = “Income from continuing operations”.
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   a   Discontinued Operations :
       i) Occurs when
          (1)


            (2)



       ii) Segment Disposal: a segment is one which represents a:
           (1)

            (2)

       iii) Disposals of assets that do not qualify as disposals of a segment of a business include
            the following:
            (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 of a product line or class of service.
       iv) Important Dates:
            (1) Measure ment Date :


            (2) Disposal Date:


            (3) Phase-Out Period:


       v) Generally reported in a separate income statement category for the gain or loss from
            disposal of a component of a business.
       vi) The results of operations of a component that has been or will be disposed of are also
            reported separately from continuing operations. The effects of discontinued
            operations are shown net of tax as a separate category, after continuing operations
            but before extraordinary ite ms. (See Illustration 4-6 on page 136. Also, see
            sample format for Multi-Step Income Statement given above.)
       vii) The phrase “Income from continuing operations” is used only when gains or losses on
            discontinued operations occur.
       viii) Form:
Chapter 4                                                                Page 8 of 14



            Note:
            (1)




            (2)




      ix) Example 1: Measurement date and disposal date are in the same period. (Recognize
          all gains and losses.)
          Ball Corp. decided on June 1, 2000 to dispose of a segment. From January 1 to June
          1, the segment had income of $50,000. Ball sold the segment on October 1, 2000 for
          a loss of $30,000. Income during the phase-out period was $10,000. The tax rate is
          40%.
Chapter 4                                                                Page 9 of 14


      x) Example 2:
         Measurement date is October 1, 2000. Disposal date is May 1, 2001.

              Realized        Estimate     Estimated     What do we       What do
            Income/Loss     Income/Loss    Gain/Loss   report in 2000?    we report
                  on             on            on                         in 2001?
             Ope rations     Ope rations    Disposal
                 [1]             [2]           [3]
            10/1 to 12/31     1/1/01 to      5/1/01
                               5/1/01
            1.




            2.




            3.




            4.




            5.
Chapter 4                                                                    Page 10 of 14



   b   Extraordinary Ite ms:
       i) Nonrecurring material items that differ significantly from the entity’s typical
          business activities.



       ii) Shown net of taxes on income statement in a separate section. (See Illustration 4-7 on
           page 138 and format for Multi-Step income statement given above.)

       iii) See page 137 for list of gains/losses that are NOT extraordinary items. List includes
            such gains/losses as gains/losses on disposal of a component of an entity
            and effects of a strike, including those against co mpetitors and major suppliers.
            These are NOT extraordinary items.


       iv) Only rarely does an event/transaction clearly meet the criteria for an extraordinary
           item. The environment in which the entity operates must also be considered.
           Examples:
           (1) Extraordinary items:




            (2) NOT Extraordinary items:




       v) Considerable judgment must be used when determining whether an item is
          extraordinary.




   c   Changes in Accounting Principle :
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       i) Include as a retrospective adjustment to financial statements. Recast the prior years’
          statement on basis consistent with newly adopted principle. Record cumulative effect
          of change for prior periods as an adjustment to beginning retained earnings of earliest
          year presented.

       ii) Disclose change in the footnotes. Changes violate the ______________ concept;
           however, the change should be justified. Retrospective approach preserves

              ________________ across years.

       iii) See example on pages 140-141 (Illustrations 4-10 and 4-11.)

   d   Unusual Gains and Losses:




       Restructuring charge:



   e   Changes in Estimates:
       i) Occasionally a company will need to change an accounting estimate.




       ii)




       iii)




       iv) Examples:
Chapter 4                                                                     Page 12 of 14


   f   Correction of Errors (Prior Period Adjustments):
       i) Occasionally companies make errors when reporting items such as revenue, stock
            options, and allowance accounts.
       ii) Record correcting entries in accounts and treat as prior period adjustments. In other
            words, adjust beginning balance of retained earnings. Record in year discovered.
       iii) See example on page 142.
   g   Summary of Irregular Ite ms : Know Illustration 4-12 on page 142.

4) Special Reporting Issues:
   a Intrape riod Tax Allocation: Allocation of tax within a period (i.e., let the tax follow the
      income.) In other words, relate tax expense for a given year to the specific items on the
      income statement. Used for: (1) income from continuing operations, (2) discontinued
      operations, and (3) extraordinary items. A separate tax effect is associated with each
      irregular item.
      i) Extraordinary Gains : See example (Illustration 4-13) on page 143.
      ii) Extraordinary Losses: See example (Illustration 4-14) on page 144.

   b   Earnings Per Share :




       The numerator is also referred to as income available to common stockholders.


       i) Required to be disclosed in the income statement.
       ii) If the company has a discontinued operation, extraordinary item, or a change in
            accounting principle, per share amounts must be reported for these line items either
            on the income statement or in the notes to the financial statements. (See Illustration
            4-17 on page 145.)
   c   Retained Earnings State ment:
       i) Net income increases R/E.
       ii) Net loss decreases R/E.
       iii) Cash and Stock Dividends decrease R/E.
       iv) Prior Period Adjustments and Changes in Accounting Principle :
            (1)

            (2)

            (3)

            (4)
Chapter 4                                                                 Page 13 of 14




       v) Example Format:
                                            Company Name
                                    Statement of Retained Earnings
                                    For the Year Ended 12/31/xx
            Balance, January 1                                   xx




            Add: Net Income                                       xx
            Less: Dividends                                       xx
            Balance, December 31                                  xx

       vi) Restrictions of Retained Earnings:
           (1) Appropriated (Restricted) Retained Earnings:



            (2) Unappropriated (Unrestricted) Retained Earnings :



            (3)




   d   Comprehensive Income :
       i) Comprehensive Income Defined:
          (1) Keeps track of items that bypass the income statement.
          (2) Includes all changes in equity during a period except those resulting from
              investments by owners and distributions to owners. It includes all revenues and
              gains, expenses and losses reported in net income, and in addition it includes
              gains and losses that bypass net income but affect stockholders’ equity. These
              items are referred to as other comprehensive income.
          (3) Other Compre hensive Income = foreign currency translation gain/loss +
              unrealized gain/loss on AFS securities + excess of additional pension liability
              over unamortized prior service cost + changes in market value of a futures
              contract that is a hedge of an asset reported at fair value.
          (4) Earnings per share information related to CI is NOT required.
Chapter 4                                                                   Page 14 of 14


      ii) Comprehensive Income Presentation: Presented in one of three ways.
          (1) Second Income State ment: See Illustration 4-19 on page 148.


            (2) Combined Income State ment:



            (3) Statement of Stockholders’ Equity: See Illustration 4-20 on page 148.




            Balance Sheet Presentation: See Illustration 4-21 on page149.

								
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