©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 1 The Income Statement and the Statement of Stockholders’ Equity Chapter 11

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 2 Learning Objective 1 Analyze a complex income statement.

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 3 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

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 4 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

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 5 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

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 6 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

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 7 Continuing Operations The company restructured operations at a loss of $8,000. Report as “Other” item – part of continuing operations, but falls outside of main business endeavor

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 8 Continuing Operations Investment capitalization rate – used to estimate the value of an investment in the capital stock of another company

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 9 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

Continuing Operations Current market value of the company Current market price per share =× $513,000 $4.75 =× # of shares of common stock outstanding 108,000 ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

11 Continuing Operations: Investment Decision Decision Rule: Estimated value > market value? BUY Estimated value = market value? HOLD Estimated value < market value? SELL In the Allied Electronics case: Estimated value of the company $450,000 < Current market value $513,000 Sell the stock

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 12 Estimated value of one share of common stock Estimated annual earnings per share = Investment capitalization rate ÷ Continuing Operations: Investment Decision

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 13 Irregular Items 1.Discontinued operations 2.Extraordinary items 3.Cumulative effect of a change in accounting principle

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 14 Discontinued Operations Segment – identifiable division of a company

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 15 Extraordinary Items Unusual for the company and infrequent Losses due to natural disasters Expropriations Exception Material gains/losses from extinguishment of debt (to be reported as extraordinary item)

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 16 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 Report in a special section of the income statement after extraordinary items

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 17 Earnings per Share (Net Income – Preferred Dividends) Earnings per Share of Common Stock ÷ Average Number of Common Shares Outstanding =

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 18 Earnings per Share of Common Stock Required to be disclosed on the income statement for all major sections Earnings per share is subject to dilution (reduction), if issue of additional shares is possible in the future

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 19 Comprehensive Income Change in total stockholders’ equity from all sources other than from owners of the business Includes net income plus unrealized gains (losses) on available-for-sale investments and foreign-currency translation adjustments

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 ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

21 Learning Objective 2 Account for a corporation’s income tax.

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 22 Accounting for Corporate Income Taxes Income tax expense – expense on income statement Income tax payable – liability on balance sheet

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 23 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 =×

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 24 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

Dec 31Income Tax Expense ($900 x.40)360 Income Tax Payable ($800 x.40)320 Deferred Tax Liability40 Recorded income tax for the year ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

26 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

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 27 Corrections to the beginning balance of Retained Earnings for errors of an earlier period Prior-Period Adjustments

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 ,000 Total$494,000 Deduct: Dividends for 2005 ( 41,000) Retained earnings balance, Dec. 31, 2005$453,000 Reporting a Prior-Period Adjustment ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

29 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

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 30 Learning Objective 3 Analyze a statement of stockholders’ equity.

Analyzing the Statement of Stockholder’s Equity ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

32 Analyzing the Statement of Stockholder’s Equity

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 33 Learning Objective 4 Understand managers’ and auditors’ responsibilities for the financial statements.

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 34 Responsibility for the Financial Statements Management issues a statement of responsibilitywith financial statements declares responsibility for financial statements and states that they conform to GAAP

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 35 Auditor Report Typically contains three paragraphs: Identifies the audited financial statements Describes how the audit was performed States the auditor’s opinion - financial statements conform to GAAP and people can rely on them for decision making

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 36 Auditor Report Unqualified (Clean) Qualified Adverse Disclaimer

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren 37 End of Chapter 11