Chapter 4 - Statement of Income and Retained Earnings

							                      Chapter 4 - Statement of Income
                          and Retained Earnings

I.   Identify the uses and limitations of an income statement.

A. The Relative Importance of the Income Statement as Providing a Measure of Profit.

     1. Income information helps interested parties predict the amount, timing, and uncertainty of
        future cash flows. Income information is useful:

       a.    for evaluating past performance of a company.

       b.    for determining the risk (uncertainty) of achieving future cash flows. 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 Statement.

     1. "Economic income:" the maximum amount that can be consumed during the period while
        leaving the entity as well off at the end as at the beginning.

       a.    There is no general agreement on how to measure "well-offness," so we measure
             income using "Accounting Income".

       b.    Accounting income does not include many items that would be included in economic
             income, e.g., accountants do not capitalize expenditures for many research and
             development and internally developed goodwill activities.

     2. Income numbers are affected by the accounting method used.

     3. Profits measured by accountants may have limited usefulness for economists.


II. Capital maintenance approach vs. Transaction approach.

A. Capital maintenance approach measures net income by computing the change in net assets
   for the period, adjusted for any additional investment made during the period.

B. The transaction approach measures the basic transactions that occur during a period and
   summarizes them in an income statement.

     The transaction approach is superior because of the additional information it provides about
     the elements of income. See Exercise 1.


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III. Single-step income statement. See example on Page 134.


IV. Multiple-step income statement.      See example on Page 135.



V. Irregular items

   In an attempt to provide financial statement users with the ability to better determine the long-
   range earning power of an enterprise, certain professional pronouncements require that the
   following irregular items be highlighted in the income statement.

A. Discontinued Operations

   To qualify as discontinued operations, the assets, results of operations, and activities of a
   segment of a business must be clearly distinguishable, physically and operationally, from the
   other assets, results of operations, and activities of the entity.


B. Extraordinary Items

   Extraordinary items are defined as material items that are unusual in nature and occur
   infrequently. Both characteristics must exist for an item to be classified as an extraordinary
   item on the income statement.

C. Unusual Gains and Losses

   Material gains and losses that are either unusual or occur infrequently, but not both, are
   excluded from the extraordinary item classification.

D. Changes in Accounting Principles

   A change in accounting principle results when an entity adopts a new accounting principle
   that is different from the one previously used. When this type of change is made, the income
   statement for the year in which the change occurred will include the cumulative effect of the
   change computed retroactively. The effect of the change (net of tax) should be disclosed as
   a separate item following extraordinary items in the income statement.

E. Changes in Estimates

   Used in the determination of income for the current period and future periods.

F. Prior period adjustments

   Adjustments to the beginning balance of retained earnings. Usually result from a correction
   of an error


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VI. Comprehensive Income

FASB Statement #130, passed recently, now requires that a computation of Comprehensive
Income be included in the financial statements. Recall from the conceptual framework that the
definition of Comprehensive Income is...?

At present, the FASB has recommended three possible presentations of Comprehensive Income.

A. A separate and second Income Statement

B. A combined Net Income and Comprehensive Income

C. Inclusion of Comprehensive Income in the Retained Earnings Statement.

                             See Examples on pages 150-152




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