2. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 1 The Income Statement and the Statement of Stockholders’ Equity Chapter 11

3. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 2 Learning Objective 1 Analyze a complex income statement.

4. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 3 Evaluating the Quality of Earnings The quality of earnings takes into consideration how net income is generated. Income from continuing operations is considered of higher quality than gains from selling off assets because it is a better predictor of future earnings.

5. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 4 Income Statement Continuing Operations Allied Electronics Corporation Income Statement Year Ended December 31, 20x5 Sales revenue$500,000 Cost of goods sold–240,000 Gross margin$260,000 Operating expenses 181,000 Operating income$ 79,000

6. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 5 Operating income$79,000 Other gains (losses): Loss on restructuring operations – 8,000 Gain on sale of machinery 19,000 Income from continuing operations before income tax$90,000 Income tax expense 36,000 Income from continuing operations$54,000 Income Statement Continuing Operations

7. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 6 Discontinued operations:$35,000, less income tax of $14,000 21,000 Income before extraordinary items and cumulative effect of change in depreciation method$75,000 Extraordinary flood loss, $20,000, less income tax savings of $8,000–12,000 Cumulative effect of change in depreciation method, $10,000, less income tax of $4,000 6,000 Net income$69,000 Income Statement Special Items

8. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 7 Earnings per share of common stock (20,000 shares outstanding): Income from continuous operations$2.70 Income from discontinued operations 1.05 Income before extraordinary item and cumulative effect of change in depreciation method$3.75 Extraordinary loss(0.60) Cumulative effect of change in depreciation method 0.30 Net income$3.45 Income Statement Earnings per Share

9. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 8 Continuing Operations The company restructured operations at a loss of $8,000. The company restructured operations at a loss of $8,000. Although the restructuring loss is part of continuing operations, it is highlighted as an “Other” item on the income statement because restructuring falls outside of the main business endeavor. Although the restructuring loss is part of continuing operations, it is highlighted as an “Other” item on the income statement because restructuring falls outside of the main business endeavor.

10. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 9 Continuing Operations Income from continuing operations can be used in estimating the value of Allied Electronics’ common stock. Income from continuing operations can be used in estimating the value of Allied Electronics’ common stock. The investment capitalization rate is used to estimate the value of an investment in the capital stock of another company. The investment capitalization rate is used to estimate the value of an investment in the capital stock of another company.

11. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 10 Continuing Operations Assume an interest rate (i) of 12% to valuate Allied. Estimated value of Allied Electronics common stock Estimated annual income in the future = Investment capitalization rate ÷ $54,000 ÷ 0.12 = $450,000 =

12. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 11 Continuing Operations Current market value of the company Number of shares of common stock outstanding Current market price per share =× $513,000 108,000$4.75 =×

13. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 12 Continuing Operations: Investment Decision The investment decision rule may take this form: If estimated value of the company Exceeds Equals Is less than Current market value of the company Buy the stock Hold the stock Sell the stock In the Allied Electronics case: Estimated value of the company $450,000 Is less than Current market value $513,000 Sell the stock

14. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 13 Investors often make their decisions based on the value of a single share of stock: Estimated value of one share of common stock Estimated annual earnings per share = Investment capitalization rate ÷ Continuing Operations: Investment Decision

15. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 14 Irregular Items 1. Discontinued operations 2. Extraordinary items 3. Cumulative effect of a change in accounting principle

16. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 15 Discontinued Operations Most large corporations engage in several lines of business. Each identifiable division of a company is called a segment of the business. A company may sell a segment of its business generating a gain or loss.

17. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 16 Extraordinary Items Unusual for the company and infrequent They include losses due to natural disasters. Expropriations

18. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 17 Extraordinary Items: Exceptions Gains and losses from discontinued operations Material gains and losses from extinguishment of debt (to be reported as extraordinary item)

19. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 18 Cumulative Effect of a Change in Accounting Principle From double-declining-balance (DBB) to straight-line depreciation From first-in, first-out (FIFO) to weighted-average cost for inventory Companies must report the cumulative effect of the accounting change on net income of prior years in a special section of the income statement after extraordinary items.

20. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 19 Cumulative Effect of a Change in Accounting Principle Cumulative effect of change in depreciation method$10,000 Less: income tax 4,000 Cumulative effect of change in depreciation method net of income tax$ 6,000

21. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 20 Earnings per Share (Net Income – Preferred Dividends) Earnings per Share of Common Stock ÷ Average Number of Common Shares Outstanding =

22. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 21 Earnings per share is subject to dilution (reduction), if issue of additional shares is possible in the future. Earnings per share is subject to dilution (reduction), if issue of additional shares is possible in the future. Earnings per share is required to be disclosed on the income statement for all the major sections. Earnings per share is required to be disclosed on the income statement for all the major sections. Earnings per Share of Common Stock

23. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 22 Reporting of Comprehensive Income Comprehensive income is the company’s change in total stockholders’ equity from all sources other than from the owners of the business. Comprehensive income is the company’s change in total stockholders’ equity from all sources other than from the owners of the business. It includes net income plus unrealized gains (losses) on available-for-sale investments and foreign-currency translation adjustments. It includes net income plus unrealized gains (losses) on available-for-sale investments and foreign-currency translation adjustments.

24. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 23 Net income$69,000 Other comprehensive income: Unrealized gain on investment$ 6,500 Less income tax (40%) 2,600 3,900 Foreign-currency translation adjustment (loss)$(9,000) Less income tax (40%) 3,600 – 5,400 Comprehensive income$67,500 Net income$69,000 Other comprehensive income: Unrealized gain on investment$ 6,500 Less income tax (40%) 2,600 3,900 Foreign-currency translation adjustment (loss)$(9,000) Less income tax (40%) 3,600 – 5,400 Comprehensive income$67,500 Statement of Comprehensive Income

25. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 24 Net income Key Figures in Financial Analysis Cash flow from operations

26. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 25 Learning Objective 2 Account for a corporation’s income tax.

27. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 26 Income tax expense, an expense on the income statement Income tax payable, a liability on the balance sheet Accounting for Corporate Income Taxes

28. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 27 Accounting for Corporate Income Taxes In general, income tax expense and income tax payable can be computed as follows: Income tax payable Taxable income (from the income tax return filed with the IRS) Income tax rate =× Income tax expense Income before income tax (from the income statement) Income tax rate =×

29. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 28 The income statement reports the results of operations. The income tax return is filed with the Internal Revenue Service to determine how much tax the company must pay the government. Accounting for Corporate Income Taxes

30. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 29 Suppose for 20x5, Nike, Inc., has pretax accounting income of $900 million on the income statement. Taxable income is $800 million on the company’s income tax return. The tax rate is 40%. Accounting for Corporate Income Taxes

31. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 30 20x5 (dollar amounts in millions) December 31 Income Tax Expense ($900 ×.40)360 Income Tax Payable ($800 ×.40)320 Deferred Tax Liability 40 Recorded income tax for the year Accounting for Corporate Income Taxes

32. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 31 Income statement Income before income tax$900 Income tax expense 360 Net income$540 Balance sheet Current Liabilities: Income tax payable$320 Long-term liabilities: Deferred tax liability 40* Total$360 *Assumes beginning tax liability was zero. Accounting for Corporate Income Taxes

33. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 32 Prior-period adjustments are corrections to the beginning balance of Retained Earnings for errors of an earlier period. Prior-Period Adjustments

34. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 33 CNN Corporation Statement of Retained Earnings Year Ended December 31, 2005 Retained Earnings, Dec. 31, 2004 (original)$390,000 Prior-period adjustment – debit to correct error in recording income tax expense of 2004 – 10,000 Retained earnings, Dec. 31, 2004, adjusted$380,000 Net income for 2005 114,000 Total$494,000 Deduct: Dividends for 2005– 41,000 Retained earnings balance, Dec. 31, 2005$453,000 Reporting a Prior-Period Adjustment

35. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 34 Restrictions on Retained Earnings Dividends and purchases of treasury stock require payments by the corporation to its stockholders. Creditors may restrict a corporation’s dividend payments and treasury stock purchases. Companies report any retained earnings restrictions in notes to the financial statements.

36. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 35 Learning Objective 3 Analyze a statement of stockholders’ equity.

37. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 36 Analyzing the Statement of Stockholder’s Equity Balance, Dec. 31, 20x4$ 80,000$160,000$130,000$(25,000) Issuance of stock 20,000 65,000 Net income 69,000 Cash dividends (21,000) Stock dividend – 8% 8,000 26,000 (34,000) Purchase of treasury stock (9,000) Sale of treasury stock 7,000 4,000 Unrealized gain on investments Foreign-currency translation adjustment Balance, Dec. 31, 20x5$108,000 $258,000$144,000$(30,000) Common Stock, $1 Par Additional Paid-in Capital Retained Earnings Treasury Stock

38. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 37 Analyzing the Statement of Stockholder’s Equity Balance, Dec. 31, 20x4$6,000 $(10,000)$341,000 Issuance of stock 85,000 Net income 69,000 Cash dividends (21,000) Stock dividend – 8% -0- Purchase of treasury stock (9,000) Sale of treasury stock 11,000 Unrealized gain on investments 1,000 1,000 Foreign-currency translation adjustment 2,000 2,000 Balance, Dec. 31, 20x5$7,000 $( 8,000)$479,000 Accumulated Other Comprehensive Income Unrealized Gain (Loss) on Investments Total Stockholders’ Equity Foreign-Currency Translation Adjustment

39. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 38 Learning Objective 4 Understand managers’ and auditors’ responsibilities for the financial statements.

40. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 39 Responsibility for the Financial Statements Management issues a statement of responsibility along with the company's financial statements. Management declares its responsibility for the financial statements and states that they conform to GAAP.

41. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 40 Auditor Report The audit report typically contains three paragraphs: The first paragraph identifies the audited financial statements. The second paragraph describes how the audit was performed, mentioning that generally accepted auditing standards are the benchmark for evaluating the audit’s quality.

42. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 41 Auditor Report The third paragraph states the auditor’s opinion that the financial statements conform to GAAP and that people can rely on them for decision making.

43. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 42 Auditor Report Unqualified (clean) Adverse Qualified Disclaimer

44. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 11 - 43 End of Chapter 11