The Income Statement and Statement of Cash Flows 4 hapter The Income Statement and Statement of Cash Flows 1 1 1 1

Objectives 1. Understand the concept 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. 2 2 2 4

Objectives 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.

Capital Maintenance Concept Concepts 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.

Capital Maintenance Concept Concepts of Income Capital Maintenance Concept 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 pay out $40,000 to stockholders and still be as well off at year-end.

Capital Maintenance Concept Concepts of Income Capital Maintenance Concept 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

Transactional Approach Concepts of Income Transactional Approach The transactional approach to income measurement is used in accounting today. 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.

Conceptual Reporting Guidelines Providing information about its operating performance separately from other aspects of performance. Presenting the results of particularly significant activities or events that predict the amounts, timing, and uncertainty of its future income and cash flows. Providing information useful for assessing the return on investment. The FASB suggests that a company’s income statement can be improved by-- Continued

Conceptual Reporting Guidelines Providing feedback that enables users to assess their previous predictions of income and its components. Providing information to help assess the cost of maintaining its operating capability. Presenting information about how effectively management has discharged its stewardship responsibilities regarding the company’s resources.

Specific Conceptual Guidelines Those items that are judged to be unusual in amount based on past experience should be reported separately. Revenues, expenses, gains, and losses that are affected in different ways by changes in economic conditions should be distinguished from one another. Sufficient detail should be given to aid in understanding the primary relationships among revenues, expenses, gains, and losses. Guidelines on how to report revenues, expenses, gains, and losses. Continued

Specific Conceptual Guidelines When the measurements of revenues, expenses, gains, or losses are subject to different levels of reliability, they should be reported separately. Items whose amounts must be known for the calculation of summary indicators (e.g., rate of return) should be reported separately.

Revenues …from delivering or producing goods, rendering services, or other activities that are the company’s ongoing major or central operations. Revenues are inflows of assets of a company or settlement of its liabilities during a period...

Revenues Recognition is the process of formally recording and reporting an item in a company’s financial statements.

Revenues A company usually recognizes revenue at the time goods are sold or services are rendered.

Expenses …rendering services, or carrying out other activities that are the company’s ongoing major or central operations. Expenses are outflows of assets of a company or incurrences of liabilities during a period from delivering or producing goods,...

Cost: Asset or Expense If a cost results in an economic resource providing future benefits, record it as an... Transaction Cost Asset Continue

Cost: Asset or Expense If a cost is a result of providing goods or services in a time period, record it as an... Transaction Cost Expense

If the benefits have been used up, the asset is changed to an expense. Cost: Asset or Expense If the benefits have been used up, the asset is changed to an expense.

Income Statement Content 1. Income from continuing operations. a. Sales revenue (net) b. Cost of goods sold c. Operating expenses d. Other items e. Income tax expense related to continued operations

Income Statement Content 2. Results from discontinued operations. a. Income (loss) from operations of discontinued segments (net of income taxes). b. Gain (loss) from disposals of discontinued segments (net of income taxes).

Income Statement Content 3. Extraordinary items (net of income taxes). 4. Cumulative effects of changes in accounting principles (net of income taxes). 5. Net income. 6. Earnings per share . That’s it!

Merchandising Company Cost of Goods Sold: BANNER CORPORATION Schedule 1: Cost of Goods Sold For Year Ended December 31, 2000 Inventory, January 1, 2000 $ 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, 2000 (38,000) Cost of goods sold $ 86,000 Merchandising Company

Manufacturing Company Cost of Goods Sold: BANNER CORPORATION Schedule 1: Cost of Goods Sold For Year Ended December 31, 2000 Raw materials used $ 35,000 Direct labor 29,000 Factory overhead Depreciation of factory items $5,100 Heat, light, and power 4,000 Indirect factory labor 7,300 Repairs and maintenance 3,400 Miscellaneous factory expense 1,200 21,000 Current manufacturing costs $ 85,000 Manufacturing Company Continued

Cost of Goods Sold: Current manufacturing costs $ 85,000 Add: Goods in process, January 1, 2000 27,000 Less: Gods in process, December 31, 2000 (29,000) Cost of goods manufactured $ 83,000 Add: Finished goods inventory, Jan. 1, 2000 41,000 Cost of goods available for sale $124,000 Less: Finished goods inventory, December 31, 2000 (38,000) Cost of goods sold $ 86,000

Income 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.

Income 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.

Income Tax Expense Income tax expense is matched against the following: income from continuing operations income (loss) from the operations of a discontinued segment gain (loss) from the disposal of a discontinued segment extraordinary items cumulative effect of any change in accounting principles any prior period adjustments any items of other comprehensive income

Single-Step Income Statement Revenues Sales revenue $143,700 Interest revenue 1,800 Dividend revenue 600 Total revenues $146,100 Expenses Cost of goods sold $ 86,000 Selling expense 10,200 General and admin. expense 16,000 Depreciation expense 7,800 Continued

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 segment A (net of $1,950 income taxes) $ 4,550 Loss on disposal of segment A (net of $3,150 income tax) (7,350) (2,800) Income before extraordinary items $ 11,200 Continued

Earnings per Common Share (8,000 shares) 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 depreciation method (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

Income Statement: Results from Discontinued 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. The sale by a diversified company of a major division that represented the company’s only activities in the electronic industry.

Income Statement: Results from Discontinued Operations Examples from APB No. 30 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.

Income Statement: Results from Discontinued Operations 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 extraordinary items $85,720 Reported net of taxes Reported net of taxes

Income Statement: Results from Discontinued Operations Discontinued operations are reported on the income statement after the continuing operations, but before extraordinary items.

Income Statement: Results from Discontinued Operations 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 extraordinary items $85,720 Component 1: operating income (loss)

Income Statement: Results from Discontinued Operations 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 extraordinary items $85,720 Component 2: gain or loss on disposal

Gain or Loss on Disposal Phase-Out Within Accounting Period Measurement Date 7/1/00 1/1/00 Pretax operating income, $8,000

Gain or Loss on Disposal Phase-Out Within Accounting Period Segment X was sold at a loss of $10,000 (pretax) Measurement Date 7/1/00 Disposal Date 12/1/00 Pretax operating income, $2,000

Gain or Loss on Disposal Phase-Out Within Accounting Period Results from discontinued operations Income from operations of discontinued Segment X (net of $2,400 income taxes) $ 5,600 Operating income 1/1-7/1 $ 8,000 Less taxes (30%) (2,400)

Gain or Loss on Disposal Phase-Out Within Accounting Period Operating income 7/1-12/1 $ 2,000 Loss on sale of segment (12,000) Loss (pretax) $(10,000) Less tax credit (30%) 3,000 Results from discontinued operations Income from operations of discontinued Segment X (net of $2,400 income taxes) $ 5,600 Loss on disposal of Segment X (net of $3,000 income tax credit) (7,000) $(1,400)

Gain or Loss on Disposal Phase-Out After Fiscal Year-End Measurement Date 8/1/00 1/1/00 Pretax operating income, $14,000 *Recognized on the measurement date *

Gain or Loss on Disposal Phase-Out After Fiscal Year-End Measurement Date 8/1/00 Fiscal Year-End 12/31/00 Disposal Date 5/1/01 Pretax operating loss, $8,000 Pretax operating income, $11,000

Gain or Loss on Disposal Phase-Out After Fiscal Year-End Results from discontinued operations Income from operations of discontinued Segment Y (net of $4,200 income taxes) $ 9,800 Operating income 1/1-8/1 $14,000 Less taxes (30%) (4,200)

Gain or Loss on Disposal Phase-Out After Fiscal Year-End Operating income 8/1/00-5/1/01 $ 3,000 Loss on sale of segment (22,000) Loss (pretax) $(19,000) Less tax credit (30%) 5,700 Results from discontinued operations Income from operations of discontinued Segment Y (net of $4,200 income taxes) $ 9,800 Loss on disposal of Segment Y (net of $5,700 income tax credit) (13,300) $(3,500)

Extraordinary 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.

Extraordinary Items Events that the APB identified as not qualifying as extraordinary: The write-down or write-off of receivables, inventories, equipment leased to others, or intangible assets. Gains or losses from exchanges or transactions of foreign currency. Gains or losses from the disposal of a business segment. Continued

Extraordinary Items Events that the APB identified as not qualifying as extraordinary (continued): Other gains or losses from the sale or abandonment of property, plant, or equipment. The effects of a strike. The adjustment of accruals on long-term contracts.

Extraordinary Items Event Report Gain (Loss) As No Unusual? Income from Continuing Operation (Other Items section) No or Infrequent? Income from Continuing Operation (Other Items section)

Extraordinary Items Event Report Gain (Loss) As No Unusual? Yes and Infrequent?

Statement of Retained Earnings Beginning 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

Statement of Retained Earnings Retained earnings is the link between a corporation’s balance sheet and its income statement.

Comprehensive Income Recall in Chapter 3 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: Continued

Comprehensive Income Any unrealized increases (gains) or decreases (losses) in the market value of investments in available-for-sale securities. Any change in the excess of its additional pension liability over unrecognized prior service costs. Certain gains and losses on “derivative” financial instruments. Any transaction adjustment from converting the financial statements of a company’s foreign operations into U. S. dollars.

Comprehensive Income On the face of its income statement. The FASB allows a company to report its comprehensive income under three alternatives: On the face of its income statement. In a separate statement of comprehensive income. In its statement of changes in stockholders’ equity. The company must display the statement containing the comprehensive income as a major financial statement in its annual report.

Comprehensive Income 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. A company is not required to report earnings per share on its comprehensive income. 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.

Statement of Cash Flows The statement of cash flows helps users to assess-- 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.

Statement of Cash Flows 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.

Statement of Cash Flows 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.

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

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