The Income Statement and Statement of Cash Flows

1. The Income Statement and Statement of Cash Flows 4

2. Learning Objectives Explain the difference between net income and comprehensive income and how we report components of the difference. LO1

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

4. Other Comprehensive Income Statement of Financial Accounting Standards No. 130 Comprehensive income includes traditional net income and changes in equity from nonowner transactions. • Changes in the market value of securities available for sale (described in Chapter 12). • Reporting a pension liability sometimes requires a reduction in shareholders’ equity (described in Chapter 17). • 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 (described in Chapter 14). • Gains or losses from changes in foreign currency exchange rates (discussed elsewhere in your accounting curriculum).

5. 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.

6. Learning Objectives Discuss the importance of income from continuing operations and describe its components. LO2

7. 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.

8. Operating Income 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

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

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

11. Learning Objectives Describe earnings quality and how it is impacted by management practices to manipulate earnings. LO3

12. Earnings Quality Earnings quality refers to the ability of reported earnings to predict a company’s future. The relevance of any historical-based financial statement hinges on its predictive value.

13. Manipulating Income and Income Smoothing “Most managers prefer to report earnings that follow a smooth, regular, upward path.”1 • Two ways to manipulate income: • Income shifting • Income statement classification 1 Bethany McLean, “Hocus-Pocus: How IBM Grew 27% a Year,” Fortune, June 26, 2000, p. 168.

14. Learning Objectives Discuss the components of operating and nonoperating income and their relationship to earnings quality. LO4

15. Operating Income and Earnings Quality Should all items of revenue and expense included in operating income be considered indicative of a company’s permanent earnings? No, not necessarily. • Operating expenses may include the following unusual items that may or may not continue in the future: • Restructuring costs • Goodwill impairment • Long-lived asset impairment • In-process research and development

16. Goodwill Impairment and Long-lived Asset Impairment Involves asset impairment losses or charges (discussed further in Chapters 10 & 11). In-process Research and Development Results from certain business combinations (discussed further in Chapter 10). 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.

17. 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.

18. Pro Forma Earnings Companies often voluntarily provide a pro forma earnings number when they announce annual or quarterly earnings. Pro forma earnings are management’s assessment of permanent earnings. The Sarbanes-Oxley Act Section 401 requires a reconciliation between pro forma earnings and earnings determined according to GAAP.

19. Separately Reported Items Reported separately, net of taxes: Discontinued operations Extraordinary items A third item, the cumulative effect of a change in accounting principle, was eliminated from separate reporting by a new accounting standard in 2005.

20. 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.

21. Learning Objectives Define what constitutes discontinued operations and describe the appropriate income statement presentation for these transactions. LO5

22. 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

23. 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.

24. 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. 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

25. Discontinued Operations Example During the year, Apex Co. sold an unprofitable component of the company. The component had a net loss from operations during the period of $150,000 and its assets sold at a loss of $100,000. Apex reported income from continuing operations of $128,387. All items are taxed at 30%. How will this appear in the income statement?

26. Discontinued Operations Example Computation of Loss from Discontinued Operations (Net of Tax Effect):

27. Discontinued Operations Example Income Statement Presentation:

28. Learning Objectives Define extraordinary items and describe the appropriate income statement presentation for these transactions. LO6

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

30. Extraordinary Items Example During the year, Apex Co. experienced a loss of $75,000 due to an earthquake at one of its manufacturing plants in Nashville. This was considered an extraordinary item. The company reported income before extraordinary item of $128,387. All gains and losses are subject to a 30% tax rate. How would this item appear in the income statement?

31. Income Statement Presentation: Extraordinary Items Example Computation of Loss from Extraordinary Item (Net of Tax Effect):

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

33. Accounting Changes

34. Learning Objectives Describe the measurement and reporting requirements for a change in accounting principle. LO7

35. Change in Accounting Principle • Occurs when changing from one GAAP method to another GAAP method • For example, a change from LIFO to FIFO • 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 the same way as a change in accounting estimate.

36. Learning Objectives Explain the accounting treatments of changes in estimates and correction of errors. LO8

37. 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

38. Change in Accounting Estimate Example On January 1, 2003, we purchased equipment costing $30,000, with a useful life of 10 years and no salvage value. During 2006, we determine that the remaining useful is 5 years (8-year total life). We use straight-line depreciation. Compute the revised depreciation expense for 2006.

39. Change in Accounting Estimate Example Record depreciation expense of $4,200 for 2006 and subsequent years.

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

41. Change in Reporting Entity A change in reporting entity is reported by restating all previous periods’ financial statements presented for comparative purposes as if the new reporting entity existed in those periods.

42. Prior Period Adjustments • Corrections of errors from a previous period • Appear in the Statement of Retained Earningsas an adjustment to beginning retained earnings • Must show the adjustment net of income taxes

43. Prior Period Adjustments Example While reviewing the depreciation entries for 2002-2007, the controller found that in 2006 depreciation expense was incorrectly debited for $150,000 when in fact it should have been debited $125,000. (Ignore income taxes.) Prepare the necessary journal entry in 2007 to correct this prior period error.

44. Prior Period Adjustments Example

45. Learning Objectives Define earnings per share (EPS) and explain required disclosures of EPS for certain income statement components. LO9

46. 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.

47. Earnings Per Share Disclosure • Report EPS data separately for: • Income from Continuing Operations • Separately Reported Items • Discontinued Operations • Extraordinary Items • Net Income

48. Learning Objectives Describe the purpose of the statement of cash flows. LO10

49. 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 presented.

50. Learning Objectives Identify and describe the various classifications of cash flows presented in a statement of cash flows. LO11