Chapter 13: Income Statement

1
Chapter 13Income Statement
2
Chapter 13 Income Statement

• I. Financial statement relationships.
• II. Income statement categories
• 1. operating revenues and expenses
• 2. other revenues and expenses
• 3. discontinued operations
• 4. extraordinary items
• III. Earnings per share
• IV. Economic consequences associated with
  reporting net income.

3
I. Relationships Among the Financial
Statements
4
II. Elements of the Income Statement

• Comprehensive income - changes in net assets from
  all non-owner sources is broken into two
  categories
• net income consisting of revenues, expenses,
  gains and losses (next slide)
• other comprehensive income consisting of equity
  adjustments not reflected in the income
  statement. Examples include
• unrealized gains and losses from revaluation of
  AFS investments.
• cumulative translation adjustment for foreign
  subsidiaries.

5
II. Elements of the Income Statement

• Revenues - increases in net assets for activities
  that constitute a companys ongoing central
  operations.
• Expenses - decreases in net assets for activities
  that constitute a companys ongoing central
  operations.
• Gains - increases in net assets for activities
  that constitute a companys peripheral
  activities.
• Losses - decreases in net assets for activities
  that constitute a companys peripheral
  activities.
• Note that account titles do not always match with
  activity (ex interest revenue and interest
  expense are peripheral activity).

6
II. Format of the I/S

• See Page 565 for example of categories
• Sales
• - COGS
• Gross profit
• - Operating expenses
• Income from operations
• Other revenues and gains
• - Other expenses and losses
• Income from continuing operations (IFCO)
• /-Discontinued operations
• /-Extraordinary items
• Net income
• (Note text also includes Change in Accounting
  Principles but the FASB statement to eliminate
  this category is expected to be issued in mid
  2005.)

7
II. Format of the I/S

• First, note the subtotals ()
• Gross profit is presented when a company uses a
  multi-step income statement more relevant for
  companies that are primarily retail or
  manufacturing (less relevant for service
  industries).
• Income from operations indicates income from
  primary, on-going activity (usual and frequent).
• Income from continuing operations (IFCO) also
  includes peripheral activity like interest
  income, as well as potentially nonrecurring
  activity like restructuring charges (unusual or
  infrequent).
• Net income also includes special items that are
  presented separately because they are significant
  activities that are usually nonrecurring.

8
II. Format of the I/S

• Now, more information on the special items
  below IFCO
• discontinued operations
• extraordinary items
• Note that each of these items is presented net
  of tax. This is necessary because income tax
  expense has already been calculated on IFCO.
  Therefore, each level below IFCO must present the
  tax effect for that component.
• This is called intraperiod tax allocation -
  allocation of income tax expense to different
  parts of the income statement.
• A partial income statement is presented on the
  next slide (and assumes a 25 tax rate).

9
II. Partial Income Statement- Sample Company
(assuming a 25 tax rate)

• Income from continuing operations 120
• Income tax expense (30)
• Income from continuing operations - net of tax
  90
• Discontinued operations
• Income from operations of discontinued segment
• (less tax effect of 25) 75
• Loss on disposal of discontinued segment
• (less tax effect of 10) (30)
• Extraordinary item
• Loss from flood damage
• (less tax effect of 9) (27)
• Net income 108

10
II. Calculations - Sample Company

• Note that net of tax can either be a
  gain/income offset by income tax expense, or a
  loss offset by an income tax reduction. In
  either case, the amount recognized is net, after
  the tax effect is subtracted out.
• In Sample Company, the calculations are based on
  a 25 income tax expense rate
• Note that the pretax amounts the net amount
  tax
• Discontinued operations
• Pretax income of 100 x 25 25 expense
• Pretax loss of 40 x 25 10 expense reduction
• Extraordinary (pretax) loss of 36 x 25 9
  expense reduction

11
II. Format - Discontinued Operations

• Discontinued operations (DO) relate to the
  disposal of a segment of a company. Because the
  disposal means that the segment activity will be
  discontinued, separate disclosures are required
  so that investors could distinguish between
  ongoing activity and nonrecurring activity.
• A segment is defined as an entire line of
  business or a separately identifiable segment.
  For example, General Motors would need to
  discontinue Chevrolet (not just a manufacturing
  plant).
• Financial statement presentation includes any
  operating income or loss to the measurement date
  (the date the board of directors declares
  intention to dispose of the segment), as well as
  any gain or loss on the disposal of the assets.

12
II. Problems with Discontinued Op.

• Does not require a sales contract to reclassify
  to discontinued operations.
• IFCO can be manipulated with the declaration (and
  reclassification) of the discontinued segment.

13
II. Format - Extraordinary Items

• Extraordinary items are defined as those
  activities that are material in amount, unusual
  in nature, and infrequent in occurrence.
• To determine, consider the natural, political,
  and economic environment of the firm.
• Examples of EI include natural disasters,
  nationalization or expropriation of assets by a
  foreign government, and one-time major economic
  transactions.
• If unusual or infrequent, but not both, report in
  other gains/losses, as part of IFCO. Examples
  include material write-down of receivables, and
  loss from employee strike.

14
I/S Classification - Class Problem

• 1. Loss in Florida from hurricane
• 2. Loss from sale of a segment
• 3. Loss from terrorist activity
• 4. Material write-off of accounts receivable
• 5.Normal write-off of accounts receivable
• 6. Loss from flood (in a 500-year flood plain)

15
II. I/S Format - Other Issues

• Consistency requires the use of the same
  accounting method from year to year.
• However, a company may choose to change to an
  alternative accounting method (ex DDB to SL or
  FIFO to average).
• Also, a company may be required to change to a
  new accounting technique by the issue of a new
  accounting standard.
• The APB required companies to show the cumulative
  effect for prior years income on the current
  income statement in a special category called
  change in accounting principle.

16
II. I/S Format - Other Issues

• This special category allowed investors to
  analyze IFCO for the current year separately from
  the effect of the cumulative change.
• Problem This cumulative calculation was
  reported as part of current net income, even
  though it relates to prior years net income.
• Solution FASB will recently (in mid 2005)
  eliminate this category from the income
  statement. Then all changes in principle will
  receive either a retroactive restatement (like
  errors of a prior period) or a prospective
  treatment (like changes in estimate).

17
III. Earnings Per Share (EPS)

• SFAS 128 simplified the presentation of earnings
  per share to two components
• basic EPS
• diluted EPS
• Calculation of Basic EPS
• Net Income - preferred dividends
  
• Average common shares outstanding
• Concept To indicate how much each common
  shareholder owns with respect to earnings.
• Preferred dividends are deducted - if declared or
  if cumulative - because they are owned by to
  preferred shareholders.
• This is a calculation of what is - the
  numerator and denominator use actual shares
  outstanding and actual net income for the year.

18
III. Earnings Per Share (EPS)

• Diluted earnings per share examines all the
  potentially dilutive securities that a company
  has issued, like convertible preferred stock,
  convertible bonds, and employee stock options.
  Although these securities have not been converted
  at year end, the calculation shows the effect
  that the shares could have on EPS.
• Calculation of Diluted EPS
• Net Income - P.D. adjustment for dilutive
  shares
• Avg. CS outstanding adjustment for dilutive
  shares
• Concept To indicate how much each common
  shareholder would own with respect to earnings
  IF all dilutive securities had been exercised at
  the beginning of the year.

19
III. Earnings Per Share (EPS)

• Diluted EPS is a what if calculation - the
  numerator and denominator are adjusted for
  potential effects of dilutive securities as of
  the securities had been converted to common stock
  at the beginning of the current year
• convertible PS
• eliminate preferred dividend (would not exist if
  converted)
• increase shares outstanding (would be larger if
  converted)
• convertible bonds
• eliminate interest expense (would not exist if
  converted)
• increase shares outstanding (would be larger if
  converted)
• stock options
• no numerator effect (generally speaking)
• increase shares outstanding (note that it is not
  a 1 for 1 conversion).
• If any of these potentially dilutive securities
  exist, the company is said to have a complex
  capital structure.

20
III. Earnings Per Share (EPS)

• Class problem
• Bush Company reported net income of 30,000 in
  2005. The company had 60,000 shares of common
  stock outstanding for all of 2005. Bush also had
  5,000 shares of convertible preferred stock
  outstanding for all of 2000. During 2005, the
  company declared a 4,000 cash dividend to
  preferred shareholders. Each share of preferred
  stock is convertible to 4 shares of common stock.
• 1.Calculate basic EPS
• 30,000 - 4,000 0.43 per share
• 60,000
• (Note that the convertibility component is
  ignored for
• basic EPS.)

21
III. Earnings Per Share (EPS)

• 2. Calculate diluted EPS
• 30,000 - 0 _ 0.38 per share
• 60,000 (5,000 x 4)
• Note that the convertibility component is assumed
  to have been exercised for diluted EPS. If the
  PS was converted to CS at the beginning of the
  year, there would have been NO preferred
  dividend, and there would have been 20,000
  additional shares of common stock outstanding all
  year.
• The effects for convertible bonds and employee
  stock options are similar for diluted EPS.

22
III. EPS Disclosure

• Separate EPS disclosure for
• Net income from continuing operations (after tax)
• Disposals of business segments
• Extraordinary items
• Calculation
• Separate dollar amount (from above categories)
  divided by number of common shares outstanding
• If diluted EPS exists, the company should also
  calculate diluted EPS for each level of
  presentation.
• If diluted EPS is antidilutive (the calculation
  is actually higher than basic EPS), the company
  does not have to present diluted EPS.

23
III. EPS Disclosure - Sample Co.(Based on
100,000 shares outstanding.)

• Basic Earnings Per Share
• Income from continuing operations 0.90
• Discontinued operations
• Income from operations of segment 0.75
• Loss on disposal (0.30)
• Extraordinary loss (0.27)
• Net income 1.08

24
III. Problems with EPS

• The numerator can be manipulated by a number of
  earning management techniques.
• The denominator can be manipulated by stock
  buybacks (treasury stock).
• The what-if presentation of diluted EPS is a
  fictitious number - it can never actually happen.
  The potentially dilutive securities have not
  been converted at year end, and they can never
  have claims to the current years income. The
  only benefit of diluted EPS is that it can
  indicate the magnitude of the maximum potential
  dilution for the future.

25
IV. Economic Consequences of Reporting Net Income

• Investors focus heavily on income and related
  indices like earnings per share and the P/E
  (price per share to earnings per share) ratio.
• Recent announcements (noting that the reported
  EPS was off the estimate by as little as a penny)
  have caused the market price of reporting
  companies to drop significantly.
• Because of investor focus, and because of
  compensation bonuses, managers continue to focus
  heavily on the bottom line, sometimes with dire
  effects.
• Expanded financial statement disclosure, and
  increased awareness by investors, may stem this
  earnings fixation.