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The Income statement and statement of cash flows

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  1. Chapter 4 The Income statement and statement of cash flows

  2. Income from Continuing Operations Revenues Inflows of resources resulting from providing goods or services to customers. Expenses Outflows of resources incurred in generating revenues. Gains and Losses Increases or decreases in equity from peripheral or incidental transactions of an entity. Income Tax Expense Because of its importance and size, income tax expense is a separate item.

  3. Operating Versus Nonoperating Income Operating Income Nonoperating Income Includes gains and losses and revenues and expenses related to peripheral or incidental activities of the company Includes revenues and expenses directly related to the principal revenue-generating activities of the company

  4. { Proper Heading Revenues & Gains { { Expenses & Losses Income Statement (Single-Step)

  5. { Proper Heading { Gross Profit { Operating Expenses { Non- operating Items Income Statement (Multiple-Step)

  6. Earnings Quality Earnings quality refers to the ability of reported earnings to predict a company’s future earnings. Transitory Earnings versus Permanent Earnings

  7. Manipulating Income and Income Smoothing • Two ways to manipulate income: • Income shifting • Income statement classification

  8. Goodwill Impairment and Long-lived Asset Impairment Involves asset impairment losses or charges. Operating Income and Earnings Quality Restructuring Costs Costs associated with shutdown or relocation of facilities or downsizing of operations are recognized in the period incurred.

  9. Nonoperating Income and Earnings Quality Gains and losses from the sale of operational assets and investments often can significantly inflate or deflate current earnings. How should those gains be interpreted in terms of their relationship to future earnings? Are they transitory or permanent? ExampleAs the stock market boom reached its height late in the year 2000, many companies recorded large gains from sale of investments that had appreciated significantly in value.

  10. Separately Reported Items Reported separately, net of taxes: Discontinued operations Extraordinary items

  11. Intraperiod Income Tax Allocation Income Tax Expense must be associated with each component of income that causes it. Show Income Tax Expense related to Income from Continuing Operations. Report effects of Discontinued Operations and Extraordinary Items NET OF RELATED INCOME TAXES.

  12. Discontinued Operations • A discontinued operation is the sale or disposal of a component of an entity. • A component comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. • A component could include: • reportable segments • operating segments • reporting units • subsidiaries • asset groups

  13. Discontinued Operations Report results of operations separately if two conditions are met: The operations and cash flows of the component have been (or will be) eliminated from the ongoing operations. The entity will not have any significant continuing involvement in the operations of the component after the disposal transaction.

  14. Reporting for Components Sold Operating income or loss of the component from the beginning of the reporting period to the disposal date. Gain or loss on the disposal of the component’s assets. Reporting for Components Held For Sale Operating income or loss of the component from the beginning of the reporting period to the end of the reporting period. An “impairment loss” if the carrying value of the assets of the component is more than the fair value minus cost to sell. Discontinued Operations

  15. Extraordinary Items • Material events or transactions • Unusual in nature • Infrequent in occurrence • Reported net of related taxes

  16. Unusual or Infrequent Items Items that are material and are either unusual or infrequent—but not both—are included as separate items in continuing operations.

  17. Accounting Changes

  18. Change in Accounting Principle • Occurs when changing from one GAAP method to another GAAP method, for example, a change from LIFO to FIFO • Most voluntary changes in accounting principles are accounted for retrospectively by revising prior years’ financial statements. • Changes in depreciation, amortization, or depletion methods are accounted for in a similar way as a change in accounting estimate.

  19. Change in Accounting Estimate Revision of a previous accounting estimate Use new estimate in current and future periods Includes treatment for changes in depreciation, amortization, and depletion methods

  20. Change in Reporting Entity If two entities combine, a single set of consolidated financial statements is generally required.

  21. Correction of Accounting Errors • Correction of errors from a previous period • Appear in the Statement of Retained Earningsas an adjustment to beginning retained earnings (show the adjustment net of income taxes) • Previous years’ financial statements that are incorrect are retrospectively restated to reflect the correction.

  22. Basic EPS Diluted EPS Net income less preferred dividends Weighted-average number of common shares outstanding for the period Reflects the potential dilution that could occur for companies that have certain securities outstanding that are convertible into common shares or stock options that could create additional common shares if the options were exercised. Earnings Per Share Disclosure One of the most widely used ratios is earnings per share (EPS), which shows the amount of income earned by a company expressed on a per share basis.

  23. Earnings Per Share Disclosure • Report EPS data separately for: • Income from Continuing Operations • Separately Reported Items • discontinued operations • extraordinary Items • Net Income

  24. Comprehensive Income An expanded version of income that includes four types of gains and losses that traditionally have not been included in income statements.

  25. Other Comprehensive Income Statement of Financial Accounting Standards No. 130 Comprehensive income includes traditional net income and changes in equity from nonowner transactions. • Net unrealized holding gains (losses) from investments (net of tax). • Gains and losses due to reviewing assumptions or market returns differing from expectations and prior service cost from amending the postretirement benefit plan. • When a derivative is designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction. • Gains or losses from changes in foreign currency exchange rates. The amount could be an addition to or reduction in shareholders’ equity. (This item is discussed elsewhere in your accounting curriculum).

  26. Accumulated Other Comprehensive Income In addition to reporting comprehensive income that occurs in the current period, we must also report these amounts on a cumulative basis in the balance sheet as an additional component of shareholders’ equity.

  27. The Statement of Cash Flows • Provides relevant information about a company’s cash receipts and cash disbursements. • Helps investors and creditors to assess • future net cash flows • liquidity • long-term solvency. • Required for each income statement period reported.

  28. Inflowsfrom: • sales to customers. • interest and dividends received. + Outflowsfor: • purchase of inventory. • salaries, wages, and other operating expenses. • interest on debt. • income taxes. _ Operating Activities Cash Flows from Operating Activities

  29. Direct Method Indirect Method Reports the cash effects of each operating activity Starts with accrual net income and converts to cash basis Direct and Indirect Methods of Reporting Two Formats for Reporting Operating Activities

  30. Direct Method Indirect Method Direct and Indirect Methods

  31. Inflowsfrom: sale of long-term assets used in the business. sale of investment securities (stocks and bonds). collection of nontrade receivables. + Outflowsfor: • purchase of long-term assets used in the business. • purchase of investment securities (stocks and bonds). • loans to other entities. _ Investing Activities Cash Flows from Investing Activities

  32. Inflowsfrom: sale of shares to owners. borrowing from creditors through notes, loans, mortgages, and bonds. _ Financing Activities Cash Flows from Financing Activities + Outflowsfor: • owners in the form of dividends or other distributions. • owners for the reacquisition of shares previously sold. • creditors as repayment of the principal amounts of debt.

  33. Noncash Investing and Financing Activities Significant investing and financing transactions not involving cash also are reported. Acquisition of equipment (an investing activity) by issuing a long-term note payable (a financing activity).

  34. End of Chapter 4