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Understanding Income Statements: Key Concepts & Practices

Explore the significance of income statements, highlighting topics like comprehensive income, continuing operations, quality of earnings, and more. Learn about the uses, limitations, and impact on equity.

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Understanding Income Statements: Key Concepts & Practices

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  1. HIGHLIGHTS OF CHAPTER 4: Income Statement February 2004

  2. SIGNIFICANT ISSUES • Comprehensive income • Continuing operations • Single-step v. Multiple-step • Quality of earnings • Operating v. Nonoperating income

  3. SIGNIFICANT ISSUES • Discontinued operations • Intraperiod tax allocation • Extraordinary items • Cumulative effect of change in accounting • Changes in estimates & errors • Earnings per share • Statement of retained earnings

  4. USES & LIMITATIONS • Evaluate past performance • Predict future performance • Predict cash flows • Shortcomings in current model • Methods chosen • Role of judgment

  5. COMPREHENSIVE INCOME • Items excluded from computation of net income • Three methods of presentation • Concept of other comprehensive income • Impact on equity in balance sheet

  6. CONTINUING OPERATIONS Operating v. Nonoperating . . . ?

  7. FORMAT Single v. multiple-step . . . ?

  8. QUALITY OF EARNINGS • Increased earnings from higher sales or lower costs v. “artificial profits” from holding gains in inventory, etc. • Quality of earnings impacts confidence of investors in financial markets • US controls 40% of world capital markets • Earnings can be reported differently & still respect GAAP • Conservative v. aggressive earnings

  9. COOKIE JAR ACCOUNTING • Establish generous reserves against losses incurred in good years and reverse the reserves in bad years • Income smoothing results with earnings understated in good years and overstated in bad years

  10. EARNINGS MANAGEMENT • Preparers must understand & reflect economic substance of transactions • Accounting rules are not simply black & white • Nature of transactions is more complex • Managing the business v. managing the earnings v. cooking the books

  11. OPERATING V. NONOPERATING • Operating • Restructuring charges • Impairment charges • Nonoperating gains & losses • Sales of assets & investments

  12. REPORTING IRREGULAR ITEMS • Modified all-inclusive approach • Discontinued operations • Extraordinary items • Cumulative effect of change in accounting principle • Changes in estimates • Earnings per share

  13. DISCONTINUED OPERATIONS • SFAS 144 supersedes SFAS 121 and APB Opinion 30 • Component of entity v. segment of business • Six conditions to qualify • Sale within one year (with exceptions) • Lower of carrying amount or fair value less cost to sell v. Net realizable value • Anticipated future losses not recorded

  14. INTRAPERIOD TAX ALLOCATION Tax follows the income . . . !

  15. EXTRAORDINARY ITEMS • Unusual • Infrequent • Tax effect

  16. CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING • Cumulative effect on prior years • Effect on current year • Tax effect

  17. CHANGES IN ESTIMATES & ERRORS • Change in estimate in period of change • Prior year restatement for errors • Tax effect

  18. EARNINGS PER SHARE • Public companies • Basic & diluted • Disclosure by category

  19. STATEMENT OF RETAINED EARNINGS • Retained earnings v. stockholders’ equity • Changes in retained earnings • Cumulative other comprehensive income • Appropriated retained earnings

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