1 The Income Statement and Statement of Cash Flows C hapter 4 An electronic presentation by Douglas...

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The Income The Income Statement and Statement and Statement of Statement of Cash FlowsCash Flows

Chapter4

An electronic presentation by Douglas Cloud

Pepperdine University

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1. Understand the concepts of income.2. Explain the conceptual guidelines for

reporting income.3. Define the elements of an income statement.4. Describe the major components of an income

statement.5. Compute income from continuing operations.

ObjectivesObjectives

ContinuedContinued

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6. Compute results from discontinued operations. 7. Identify extraordinary items. 8. Prepare a statement of retained earnings. 9. Report comprehensive income.10. Explain the statement of cash flows.11. Classify cash flows as operating, investing, or

financing.

ObjectivesObjectives

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Concepts of IncomeConcepts of Income

Capital Maintenance Concept

Under this concept, corporate income for a period of time is the amount that may be paid

to stockholders during that period and still enable the corporation to be as well off at the end of the period as it was at the beginning.

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Assume a corporation has net assets of $50,000 at the beginning and $90,000 at the end of the year, and that no additional investments or withdrawals were made.

Ending net assets $90,000 Less: Additional investment 0 Ending net assets excluding investment $90,000 Less: Beginning net assets (50,000 )Total income for the year $40,000

The corporation could The corporation could pay out $40,000 to pay out $40,000 to

stockholders and still be stockholders and still be as well off at year-end.as well off at year-end.



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Assume a corporation has net assets of $45,000 at the beginning and $80,000 at the end of the year. Stock-

holders made additional capital investments of $10,000.

Ending net assets $80,000 Less: Additional investment (10,000 ) Ending net assets excluding investment $70,000 Less: Beginning net assets (45,000 )Total income for the year $25,000



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Transactional Approach

Under this concept, a company records its net assets at their historical cost, and it does

not record changes in the asset and liabilities unless a transaction, event, or circumstance has occurred that provides reliable evidence of a change in value.

The transactional approach to income measurement is used in accounting today.


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Transactional Approach


A corporation’s net income for an accounting period currently is measured as follows:

Net income = Revenues – Expenses + Gains - Losses

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Conceptual Reporting GuidelinesConceptual Reporting Guidelines

1. Providing information about its operating performance separately from other aspects of performance.

2. Presenting the results of particularly significant activities or events that predict the amounts, timing, and uncertainty of its future income and cash flows.

3. Providing information useful for assessing the return on investment.

The FASB suggests that a company’s income

statement can be improved by--

ContinuedContinued

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Conceptual Reporting GuidelinesConceptual Reporting Guidelines

4. Providing feedback that enables users to assess their previous predictions of income and its components.

5. Providing information to help assess the cost of maintaining its operating capability.

6. Presenting information about how effectively management has discharged its stewardship responsibilities regarding the company’s resources.

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Specific Conceptual GuidelinesSpecific Conceptual Guidelines1. Those items that are judged to be unusual in

amount based on past experience should be reported separately.

2. Revenues, expenses, gains, and losses that are affected in different ways by changes in economic conditions should be distinguished from one another.

3. Sufficient detail should be given to aid in understanding the primary relationships among revenues, expenses, gains, and losses.

Guidelines about how to report revenues, expenses,

gains, and losses.

ContinuedContinued

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Specific Conceptual GuidelinesSpecific Conceptual Guidelines

4. When the measurements of revenues, expenses, gains, or losses are subject to different levels of reliability, they should be reported separately.

5. Items whose amounts must be known for the calculation of summary indicators (e.g., rate of return) should be reported separately.

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Revenues are inflows of assets of a company or

settlement of its liabilities during a period...

RevenuesRevenues

…from delivering or producing goods, rendering services, or other activities that are the company’s

ongoing major or central operations.

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RevenuesRevenues

Revenue recognition is the process of formally

recording and reporting an item in a company’s financial statements.

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RevenuesRevenues

A company usually recognizes revenue at the

time goods are sold or services are rendered.

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ExpensesExpensesExpenses are outflows of assets of

a company or incurrences of liabilities during a period from

delivering or producing goods,...

…rendering services, or carrying out other activities

that are the company’s ongoing major or central operations.

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Cost: Asset or ExpenseCost: Asset or Expense

Transaction CostCost

ContinueContinue

If a cost results in an economic resource providing future

benefits, record it as an...

Asset

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If a cost is a result of providing goods or services in a time

period, record it as an...

Expense

Transaction CostCost

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If the benefits have been used up, the asset is

changed to an expense.

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Income Statement ContentIncome Statement Content

a. Sales revenue (net)b. Cost of goods soldc. Operating expensesd. Other itemse. Income tax expense related to

continued operations

1. Income from continuing operations

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Income Statement ContentIncome Statement Content2. Results from discontinued operations

a. Income (loss) from operations of discontinued significant components (net of income taxes).

b. Gain (loss) from disposals of discontinued significant components (net of income taxes).

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3. Extraordinary items (net of income taxes)4. Cumulative effects of changes in

accounting principles (net of income taxes)5. Net income6. Earnings per share

Income Statement ContentIncome Statement Content

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Cost of Goods Sold:Cost of Goods Sold:BANNER CORPORATIONSchedule 1: Cost of Goods SoldFor Year Ended December 31, 2004Inventory, January 1, 2004 $ 41,000 Purchases $80,300 Freight-in 5,500 Cost of purchases $85,800 Less: Purchases returns (2,800 )Net purchases 83,000 Cost of goods available for sale $124,000 Less: Inventory, December 31, 2004 (38,000 )Cost of goods sold $ 86,000

Merchandising Company

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Cost of Goods Sold:Cost of Goods Sold:BANNER CORPORATIONSchedule 1: Cost of Goods SoldFor Year Ended December 31, 2004Raw materials used $ 35,000 Direct labor 29,000 Factory overhead

Depreciation of factory items $5,100Heat, light, and power 4,000Indirect factory labor 7,300Repairs and maintenance 3,400Miscellaneous factory expense 1,200 21,000

Current manufacturing costs $ 85,000

Manufacturing Company

ContinuedContinued

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Cost of Goods SoldCost of Goods Sold:

Current manufacturing costs $ 85,000 Add: Goods in process, January 1, 2004 27,000 Less: Gods in process, December 31, 2004 (29,000 )Cost of goods manufactured $ 83,000 Add: Finished goods inventory, Jan. 1, 2004 41,000 Cost of goods available for sale $124,000 Less: Finished goods inventory,

December 31, 2004 (38,000 )Cost of goods sold $ 86,000

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Income Tax ExpenseIncome Tax Expense

Interperiod tax allocation involves allocating a corporation’s income tax obligation as an expense to various

accounting periods because of temporary (timing) differences between its taxable

income and pretax financial income.

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Income Tax ExpenseIncome Tax Expense

Intraperiod tax allocation involves allocating a corporation’s total income tax

expense for a period to the various components of its net income, retained

earnings, and other comprehensive income.

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1. Income from continuing operations2. Income (loss) from the operations of a discontinued

component3. Gain (loss) from the disposal of a discontinued

component4. Extraordinary items5. Cumulative effect of any change in accounting principles6. Any prior period adjustments7. Any items of other comprehensive income

Income Tax ExpenseIncome Tax ExpenseIncome tax expense is matched against the following:

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Single-Step Income StatementSingle-Step Income Statement

RevenuesSales revenue $143,700 Interest revenue 1,800 Dividend revenue 600 Total revenues $146,100

ExpensesCost of goods sold $ 86,000 Selling expense 10,200 General and admin. expense 16,000 Depreciation expense 7,800

ContinuedContinued

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Expenses (continued)Loss on sale of equipment 4,000 Interest expense 2,100 Income tax expense 6,000

Total expenses (132,100 )Income from continuing operations $ 14,000 Results from discontinued operations

Income from operations of significant component A (net of $1,950 income taxes) $ 4,550 Loss on disposal of significant component A (net of $3,150 income tax) (7,350 ) (2,800 )

Income before extraordinary items $ 11,200 ContinuedContinued

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Income before extraordinary items $ 11,200 Extraordinary loss from explosion

(net of $750 income tax credit) (1,750 )Cumulative effect on prior years’

income of change in depreciationmethod (net of $600 income taxes) 1,400

Net income $ 10,850 Earnings per

Common Share (8,000 shares)Components of Income

Income from continuing operations $ 2.80 Results from discontinued operations (0.56 ) Extraordinary loss from explosion (0.35 ) Cumulative effect on prior years’ income 0.28 Net income $2.17

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Income Statement: Results from Income Statement: Results from Discontinued OperationsDiscontinued Operations

Examples from APB No. 30

The sale by a diversified company of

a major division that represented the company’s only activities in the

electronic industry.

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The sale by a meat packing company of its 20% interest in a professional

football team.

The sale by a meat packing company of its 20% interest in a professional

football team.

Examples from APB No. 30

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FASB Statement No. 142

A component of a company involves operations and cash flows that can be

clearly distinguished, operationally and for the financial reporting purposes,

from the rest of the company.

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Income from continuing operations $93,000 Results from discontinued operations:

Income from operations of discontinued Division X (net of $2,880 income taxes) $ 6,720 Loss on disposal of Division X (net of $6,000 income tax credit) (14,000 ) (7,280 )

Income before $85,720 Reported net of taxesReported net of taxes

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Note that discontinued operations are reported on the income

statement after the continuing operations, but before extraordinary items.


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Income before extraordinary items $85,720


Component 1: operating income (loss)

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Component 2: gain or loss on disposal



Income before extraordinary items $85,720


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On September 30, 2004 Duvall Company sells Division C (a component of its operations) for $102,000 and incurs $2,000 of legal fees and closing costs. At the

time of the sale, the book values of Division C’s assets and liabilities are $150,000 and $80,000, respectively. Duvall Company is subject to a 30% income tax rate.

Sale Illustration

ContinuedContinued

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Net cash received ($102,000 – $2,000) $100,000Book value of net assets of Division C:Assets $150,000

Liabilities (80,000 )Net book value (70,000 )

Pretax gain $ 30,000Income tax (30%) (9,000 )After-tax gain $ 21,000

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FASB Statement No. 144 requires that all of the following criteria be met to qualify for “held for sale”:

1. Management has committed to a plan to sell the component.2. The component is available for immediate sale in its present

condition.3. Management has begun an active program to locate a buyer.4. The sale is probable within one year.5. The component is being marketed for sale at a price that is

reasonable in relation to component’s fair market value.6. It is unlikely that management will make significant changes

to the plan.Held for Sale

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Elmo Company classifies Division M as “held for sale” at the end of 2004. Elmo Company expects to sell

Division m in 2005 and estimates the fair value of the division is $200,000. At the end of 2004, the book value of Division M is $240,000. The company is

subject to a 30% income tax rate.

Held-for-Sale Illustration

ContinuedContinued

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Fair value of Division M $200,000Book value of net assets of Division M:Assets $330,000


Pretax loss $ (40,000 )

End of 2004

Loss on Write-Down of Held-For-SaleDivision M (pretax) 40,000

Assets of Division M 40,000

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Disclosures Required by FASB Statement No. 144

A description of the facts and circumstances leading up to the sale, and, if held-for-sale, the expected manner and timing of the sale.

The revenues and pretax income (loss) of the component included in its operating income (loss) reported in the results of discontinued operations section of the company’s income statement.

ContinuedContinued

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Disclosures Required by FASB Statement No. 144

If not reported separately on its income statement, the gain (loss) on the sale and the caption on the income statement that includes the gain (loss).

If not separately reported on its balance sheet, the book value of the major classes of assets and liabilities.

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Gain or Loss on SaleGain or Loss on Sale

On September 30, 2004 Duvall Company sells Division C (a significant component of its

operations) for $102,000 and incurs $2,000 of legal fees and closing costs. At the time of the sale, the

book values of Division C’s assets and liabilities are $150,000 and $80,000, respectively. Duvall

Company is subject to a 30% income tax rate.

ContinuedContinued

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Net cash received ($102,000 - $2,000) $100,000Book value of net assets of Division C:Assets $150,000


Pretax gain $ 30,000Income tax (30%) (9,000 )After-tax gain $ 21,000

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Sale in a Later Accounting PeriodSale in a Later Accounting Period

When a company classifies a significant component as held for sale, it records and

reports the component at the lower of (1) its book value (book value of assets minus book value of liabilities) or (2) its fair value (the

amount at which the assets and liabilities as a whole could be sold in a current single

transaction) less any cost to sell.

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To review the criteria that must be met under FASB Statement No. 144 for a

significant component to be considered “held for sale” click on the button below. To return to the example (Slide 50), click

on the “held for sale” banner at the bottom of the review slide. To skip the review,

simply press the Enter key.

Go to review

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Sale in a Later Accounting PeriodSale in a Later Accounting Period

Elmo Company classifies Division M (a significant component of its operations) as “held

for sale” at the end of 2004. Elmo Company expects to sell Division M in 2005 at its fair value

of $200,0000 (consisting of assets with a fair value of $300,000 and liabilities with a fair value of $100,000). At the end of 2004, the book value

of Division M is $240,000 (assets book value, $330,000; liabilities book value, $90,000). The company is subject to a 30% income tax rate.

ContinuedContinued

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Fair value of Division M $200,000Book value of net assets of Division C:Assets $330,000


Pretax loss $ (40,000 )End of 2004

Loss on Write-Down of Held-For-SaleDivision M (pretax) 40,000

Liabilities of Division M 10,000Assets of Division M 30,000

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Extraordinary ItemsExtraordinary Items

An extraordinary item is an event or

transaction that is both unusual in nature and

infrequent in occurrence.

Unusual nature—the underlying event or

transaction possesses a high degree of

abnormality and is of a type clearly unrelated to,

or only incidentally related to, the ordinary and typical activities of

the company.

Infrequency of occurrence—the

underlying event or transaction is of a type that is not reasonably

expected to recur in the foreseeable future.

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1. The write-down or write-off of receivables, inventories, equipment leased to others, or intangible assets.

2. Gains or losses from exchanges or transactions of foreign currency.

3. Gains or losses from the disposals of a business component.

Extraordinary ItemsExtraordinary ItemsEvents that the APB Opinion No. 30 identified as not qualifying as extraordinary:

ContinuedContinued

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4. Other gains or losses from the sale or abandonment of property, plant, or equipment.

5. The effects of a strike.6. The adjustment of accruals on long-term

contracts.7. The effect of a terrorist attack.

Extraordinary ItemsExtraordinary ItemsEvents that the APB Opinion No. 30 identified as not qualifying as extraordinary:

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One other item is required to be reported as an extraordinary item. As prescribed by FASB

Statement No. 141, when a company purchases another company and pays less than the fair value of the other company, it reports

the difference as an extraordinary gain.

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Unusual?NoNo

Report Gain (Loss) As

Income from Continuing Operation (Other Items section)

Infrequent?NoNo

or

Income from Continuing Operation (Other Items section)

Event

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Event

Unusual?NoNo

Report Gain (Loss) As

Infrequent?NoNo

orYesYes

YesYes

andExtraordinary

Item

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Change in Accounting PrincipleChange in Accounting Principle

A change in accounting principle occurs when a company adopts a generally

accepted accounting principle different from the one it has been using in its

financial reporting.

In most instances, a company reports the cumulative effect on prior years’ earnings in its net income for

the year in which it makes the change.

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Change in Accounting EstimateChange in Accounting Estimate

When a company changes an accounting estimate, it accounts for

the change in the current year, and in future years if the change affects

both.

Because companies present financial information on a periodic basis, accounting

estimates are necessary, and changes in these estimates frequently occur.

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Statement of Retained EarningsStatement of Retained Earnings

Retained earnings is the link between a

corporation’s balance sheet and its income statement.

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Statement of Retained EarningsStatement of Retained EarningsBeginning retained earnings $59,200 Plus (minus): Prior period adjustment

(net of $2,400 income taxes) 5,600 Adjusted beginning retained earnings $64,800 Plus (minus): Net income (loss) 22,300

$87,100 Minus: Dividends (specifically identified,

including per share amounts) (9,400 )Ending retained earnings $77,700

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Comprehensive IncomeComprehensive Income

Recall that the FASB now requires companies to report their comprehensive income (or loss)

for the accounting period.

A company’s comprehensive income consists of two parts: net income and other

comprehensive net income. Currently, there are four items of a company’s other

comprehensive income:ContinuedContinued

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1. Any unrealized increases (gains) or decreases (losses) in the market value of investments in available-for-sale securities.

2. Any change in the excess of its additional pension liability over unrecognized prior service costs.

3. Certain gains and losses on “derivative” financial instruments. 4. Any transaction adjustment from converting the financial

statements of a company’s foreign operations into U. S. dollars.


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On the face of its income statement. In a separate statement of comprehensive

income. In its statement of changes in stockholders’

equity.

Comprehensive IncomeThe FASB allows a company to report its comprehensive income under three alternatives:

The company must display the statement containing the comprehensive income as a major financial

statement in its annual report.

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In reporting its comprehensive income, a

company must add its other comprehensive

income to net income.

The other comprehensive income items may be reported at their gross amounts or net of tax.

If each item is reported at its gross amount, then the total

pretax amount of other comprehensive income must

be reduced by the related income tax expense.

A company is not required to report

earnings per share on its comprehensive income.

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Statement of Cash FlowsStatement of Cash Flows

The company’s ability to generate positive future cash flows.

The company’s ability to meet its obligations and pay dividends.

The company’s need for external financing. The reasons for differences between the company’s net

income and associated cash receipts and payments. Both the cash and noncash aspects of the company’s

investing and financing transactions.

The statement of cash flows helps users to assess--

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Operating activities include all the transactions and other events related to its earnings process.

Investing activities include all the transactions involving acquiring and selling long-term investment, acquiring and selling property, plant, and equipment,

and lending money and collecting on loans.

Financing activities include all the transactions involved in obtaining and disbursing resources from and to owners and repaying the amounts borrowed.

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The statement of cash flows includes three major sections.

(1) Net cash flow from operating activities.

(2) Cash flows from investing activities.

(3) Cash flows from financing activities.

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• To eliminate certain amounts that were included in net income but that did not involve a cash inflow or cash outflow for operating activities.

• To include any changes in the current assets (other than cash) and current liabilities involved in the company’s operating cycle that affect cash flow differently than net income.

Statement of Cash FlowsStatement of Cash FlowsIn the Net Cash Flows from Operating Activities section, net income is listed first and then adjustments are made to net income (indirect method)--

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• Receipts from selling investments in stocks and debt securities.

• Receipts from selling property, plant, and equipment.• Payments for investments in stocks and debt

securities.• Payments for purchases of property, plant, and

equipment.

Statement of Cash FlowsStatement of Cash FlowsThe Cash Flows From Investing Activities section includes all the cash inflows and outflows involved in investing activities transactions of the company. Common investing activities are--

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• Receipts from the issuance of debt securities.• Receipts from the issuance of stocks.• Payment of dividends.• Payments to retire debt securities.• Payments to reacquire stock.

Statement of Cash FlowsStatement of Cash FlowsThe Cash Flows From Financing Activities section includes all the cash inflows and outflows involved in the financing activities transactions of the company. Common financing activities are--

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