The Income Statement and Measures of Performance

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Chapter 6

• The Income Statement and Measures of Performance

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Chapter 6--Learning Objectives

• 1. Explain the different concepts of income,
  cash, economic, and accrual-based income measures
  

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Concepts of Income

• Cash Basis
• Economic
• Accrual Basis

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Cash Basis Income
Income Cash inflow - Cash outflow
Not reported as income under GAAP Reported in
Statement of Cash Flows as net cash flow from
operating activities
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Economic Income
Based on concept of well-offness Economic
Income is the maximum amount that can be
distributed to owners during the accounting
period and leave the business as well off at the
end of the accounting period as it was at the
beginning of the period
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Economic Income

• A Capital maintenance concept of income
• Income is the change in value of the net assets
  of the business during the accounting period
• Measurements of assets and liabilities would be
  based on fair value at the balance sheet date,
  i.e., the present value of expected future cash
  flows

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Accounting IncomeAccrual Basis Income

• Transactions based
• The change in net assets is measured utilizing
  historical cost (with modifications)
• A financial capital maintenance concept of income

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Accrual Basis IncomeCharacteristics

• Revenue recognized when earned
• Expenses matched with revenue
• Based on historical cost

Income Revenue Gains - Expenses - Losses
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SFAC 1

• Objectives Of Financial Reporting
• To provide information
• Useful in Investment Credit Decisions
• Useful in Assessing Cash Flow Prospects
• About Enterprise Resources, Claims to Those
  Resources, Changes in Them

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SFAC 1 Enterprise Performance Earnings

• The primary focus of financial reporting
• Expectations about future performance are
  commonly based on past performance
• Accrual based earnings provide a better
  indication of performance than cash flows
• Relate Benefits and Costs of Operations, Events
  Circumstances that affect the Enterprise

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Accrual Basis Accounting Income

• Consistent with the concept of Financial Capital
  Maintenance
• Income the change in net assets occurring
  during the period excluding transactions with
  owners

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Chapter 6--Learning Objectives

• 2. Demonstrate the format of the income statement
  

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Income Statement

• Includes the following elements of financial
  statements
• Revenues
• Expenses
• Gains Losses

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Income Statement Formats

• Single Step
• Multiple Step

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Single Step
Revenues Gains minus Expenses Losses
Including Income Taxes
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Single-step income statement form

• Revenues
• Sales revenue XXX
• Interest income XXX
• Dividend revenue XXX
• Gain on sale of equipment XXX
• Other income XXX
• Total revenue XXX

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Single-step income statement form

• Expenses
• Cost of goods sold XXX
• Selling administrative expense XXX
• Interest expense XXX
• Loss on sale of land XXX
• Other expense XXX
• Provision for income taxes XXX
• Total expenses XXX

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Multiple-step income statement form

• Sales revenue XXX
• Cost of goods sold XXX
• Gross profit XXX
• Operating expenses
• Selling administrative expense XXX
• Other operating expenses XXX
• Operating expenses XXX
• Income from operations XXX

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Multiple-step income statement form

• Other revenue and gains
• Interest revenue XXX
• Gain on sale of equipment XXX
• Other expenses and losses
• Loss on sale of land XXX
• Other expenses XXX
• Other revenue (expense) XXX
• Income before taxes XXX
• Provision for income taxes XXX
• Net Income XXX

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Income statement form

• Both single-step and multi-step formats are
  acceptable
• APB Opinion No. 30 requires special presentation
  of
• Discontinued operations
• Extraordinary items
• Cumulative effects of changes in accounting
  principles

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Elements of the income statement

• Sales and operating revenues
• Revenues from sales less discounts, returns and
  allowances
• Cost of goods sold
• Beginning inventory plus purchases (net of
  returns allowances but including
  transportation) less ending inventory
• Operating expenses
• Normally classified as administrative expenses
  and selling expenses

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Elements of the income statement

• Non-operating items
• Revenues, expenses, gains and losses outside the
  normal operations of the business
• Provision for income taxes
• Includes federal, state and local income taxes
• Special reporting items
• Discontinued operations, extraordinary items and
  accounting changes

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Chapter 6--Learning Objectives

• 3. Specify which circumstances qualify as special
  reporting items, and explain how to measure and
  report those special items on the income
  statement

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Extraordinary ItemsAPB 30

• Absent discontinued operations,
• the following main captions should be reported
  in the income statement if extraordinary items
  are reported
• Income before Extraordinary Item XXX
• Extraordinary Item (less applicable
  taxes of ____) XXX
• Net Income XXX

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Net sales XXX CGS XXX Gross
profit XXX Operating expenses XXX Income
from operations XXX Other(non operating
items) XXX Income before tax extraordinary
item XXX Income tax XXX Income before
extraordinary item XXX Extraordinary item (net
of tax) XXX Net income XXX
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Extraordinary Items? APB 30

• Events and transactions that are distinguished by
  their unusual nature and infrequency of occurrence

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Unusual Nature

• Abnormal
• Significantly different from ordinary and typical
  activities of the entity
• Beyond the control of management

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Unusual Nature

• Primary consideration
• The environment in which the entity operates
• Characteristics of the industry
• Geographical location
• Extent of governmental regulation

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Infrequent

• Not reasonably expected to recur in the
  foreseeable future
• Take into account the environment in which the
  entity operates
• Prior occurrence provides evidence to assess the
  probability of recurrence

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Extraordinary ItemsExamples

• Results of a major casualty, e.g.,
• Earthquake
• Expropriation
• Prohibition under a newly enacted law or
  regulation

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Items which are NEVER considered to be
extraordinary

• Write-downs of receivables and inventories
• Foreign exchange gains and losses
• Gains and losses from sale or abandonment of
  property, plant and equipment
• Labor disturbances

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Accounting Change APB 20

• Change in Accounting Principle
• Change in Reporting Entity
• Change in Estimate

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Change in Accounting Principle

• Changing from one generally accepted accounting
  principle to another
• Examples
• Change from LIFO to FIFO
• Change from SYD Depreciation to Straight-line

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Change in Reporting Entity

• When a company has investments in other entities
  over which it exercises significant influence or
  control
• Change
• how the investment is reported in the balance
  sheet and income statement
• Example
• Change from the equity method of accounting to
  consolidation

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Change in Estimate

• Change in good faith estimate
• Prompted by
• Environmental changes
• Availability of new information
• Examples
• Change in estimate of useful life of building
• Change in fair value of investments in trading
  securities

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Accounting Treatments for Accounting Changes

• Current
• Retroactive
• Prospective

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Current Treatment

• Report Cumulative Effect in the Income Statement
• Do not restate prior financial statements
• Report Pro-forma Effects for
• Income before extraordinary items
• Net Income

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Cumulative effect in income statement APB
30 Income from 0perations XXX Other(non
operating items) XXX Income before
extraordinary item and cumulative effect of
accounting change XXX Extraordinary item (less
taxes of ____) XXX Cumulative effect of
accounting change (less taxes
of _____) XXX Net income XXX
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When to apply Current Treatment

• Changes in Principle
• Exceptions are treated retroactively
• Example
• Change from Straight-line Depreciation to Double
  Declining Balance

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Retroactive Treatment

• Report cumulative effect as an adjustment to the
  beginning balance of Retained Earnings
• Restate prior financial statements
• No need to report separate Pro-formas

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Retroactive treatment is required for

• Changes from LIFO
• Changes to or from full cost method in the
  extractive industry
• Changes to the equity method of accounting for
  investments in stock
• Changes in accounting for long-term contracts
• Changes from retirement/replacement accounting to
  other depreciation methods
• Changes associated with an IPO of stock

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Discontinued operations APB 30 Income from
continuing operations before tax XXX Income
tax expense XXX Income from continuing
operations XXX Discontinued operations (less
taxes) XXX Extraordinary Items (less taxes) Cum
effect of accounting change (less
taxes) XXX Net income XXX
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Discontinued Operations APB 30

• Separately identifiable segment which is being
  disposed of
• A major class of business
• Separately identifiable assets, liabilities,
  revenues, and expenses

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Discontinued Operations In the Income
Statement

• Two components
• Income (loss) from operations
• Gain (loss) from disposal

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Discontinued Segment Income (Loss) from
Operations

• Disclosed when the decision to discontinue was
  made after the beginning of the year
• Amount of income (loss) is determined from the
  beginning of the year to the date the decision is
  made to discontinue a segments operations
  (measurement date)

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Gain (loss) from disposal of segment assets

• Gain (loss) during the phase-out period
• Phase-out period can extend to subsequent
  accounting period

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The Possibilities

• Measurement Date Disposal Date occur in same
  accounting period
• Measurement Date occurs in current period,
  Disposal Date occurs in a subsequent accounting
  period

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Measurement Date Disposal Date in Same Period
Year End
Beginning of year
Measurement Date
Disposal Date
A
B
Phase Out Realized Gain (Loss)
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Disposal Date in Subsequent Period
Year End 2
Beginning of year
Measurement Date
Year End 1
Disposal Date
A
B
C
Realized Gain (Loss)
Estimated Gain (Loss)
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Disposal During a Subsequent Period - Special
Rules

• A realized Loss on disposal
• Increase by estimated loss
• Decrease by estimated gain (but only to zero)
• A realized Gain on disposal
• Decrease by estimated loss
• Do not increase by estimated gain

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Chapter 6--Learning Objectives

• 4. Specify which circumstances qualify as
  prior-period adjustments, and explain how to
  measure, account for, and report those
  adjustments in the financial statements

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Prior period adjustments

• SFAS No. 16 specifies three types
• 1. Corrections of errors
• 2. Adjustments involving tax loss
  carryforwards of purchased subsidiaries
• 3. Others specified by the FASB
• Our focus is on the first type

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Prior period adjustmentsRequire Retroactive
Treatment

• Do not affect income in the year of discovery
• Are NOT reported on the income statement
• Adjustments are made directly to the Retained
  Earnings account
• Adjustments are reported on the Retained Earnings
  statement

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Prepare the statement of retained earnings
Retained earnings, Jan. 1, 2000, (as previously
reported) 900,000 Correction of error in
depreciation expense not charged in prior
periods (net of 7,000 tax) ( 15,000)
Retained earnings, Jan. 1, 2000,
(restated) 885,000 Net income
110,000 Retained earnings, Dec 31, 2000 995,000
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Chapter 6--Learning Objectives

• 5. Illustrate the computations and reporting
  requirements for earnings-per-share presentations

EPS
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EPS

• What a share of common stock earned during the
  accounting period
• Numerator Income to Common Stockholders
• Subtract preferred dividends
• Denominator Weighted average number of shares
  outstanding

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Must report EPS for

• Income from Continuing Operations
• Discontinued Operations
• Extraordinary Items
• Net Income

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Chapter 6--Learning Objectives

• 6. Understand corporate risk and profitability
  analysis, using the basic ratios and categories
  of ratios

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Profitability analysis

• The most common measure is return on assets (ROA)
  calculated as follows
• Net income (Interest expense) x (1 - Tax
  rate)
• Average total assets

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Return on assets

• Measures the return on the average capital
  invested in assets during the accounting period.
• Since both lenders and stockholders provide
  capital, ROA includes income before interest and
  its associated tax benefit.

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Risk Analysis

• ROA ignores the means by which operations are
  financed.
• Also, investors are interested in the return to
  common stock
• Hence, a frequent adjustment is to calculate the
  return on equity (ROE), sometimes called return
  on common equity (ROCE)

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Return on common equity

• Return on assets
• Less Return to creditors
• Less Return to preferred shareholders
• Equals Return to common shareholders
• or
• Net income - preferred dividends
• Average common equity