1 The Income Statement and the Statement of Stockholders’ Equity Chapter 11

2 Learning Objective 1 Analyze a complex income statement.

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

4 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

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

6 Most Analysts and Investors Focus on Earnings from Continuing Operations Gains (or losses) from discontinued operations, extraordinary items, or effects of accounting principles changes are non-recurrent Gains (or losses) from discontinued operations, extraordinary items, or effects of accounting principles changes are non-recurrent These items are said to be “below the line,” the line being earnings from continuing operations These items are said to be “below the line,” the line being earnings from continuing operations Investors tend to factor these out in evaluating the company’s earnings prospects Investors tend to factor these out in evaluating the company’s earnings prospects

7 Earnings per share of common stock (20,000 shares outstanding): Income from continuing 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

8 Continuing Operations The company restructured operations at a loss of $8,000. 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 Report as “Other” item – part of continuing operations, but falls outside of main business endeavor

9 Items Which Are “Below the Line” 1.Discontinued operations 2.Extraordinary items 3.Cumulative effect of a change in accounting principle 4.These items must be presented in the above order on the statement of income

10 Discontinued Operations Segment – identifiable division of a company is sold at a gain or loss Segment – identifiable division of a company is sold at a gain or loss Must get completely out of that line of business to qualify as a segment disposal, and therefore “below the line” Must get completely out of that line of business to qualify as a segment disposal, and therefore “below the line” Otherwise the gain or loss from disposition is “above the line,”under the caption,“Other Gains and Losses” Otherwise the gain or loss from disposition is “above the line,”under the caption,“Other Gains and Losses”

11 Extraordinary Items To qualify as an extraordinary item, the item must be Unusual and infrequent, e.g.: To qualify as an extraordinary item, the item must be Unusual and infrequent, e.g.: Losses due to natural disasters Losses due to natural disasters Expropriations (seizure) of properties Expropriations (seizure) of properties If the item is not unusual and infrequent, it must be disclosed “above the line,”e.g.: If the item is not unusual and infrequent, it must be disclosed “above the line,”e.g.: Corporate restructuring charges Corporate restructuring charges Disposing of a single plant location, but not getting completely out of that line of business. [There are remaining plants in that line of business.] Disposing of a single plant location, but not getting completely out of that line of business. [There are remaining plants in that line of business.]

12 Cumulative Effect of a Change in Accounting Principle An example: changing fisrom double-declining- balance (DBB) to straight-line depreciation An example: changing fisrom double-declining- balance (DBB) to straight-line depreciation From first-in, first-out (FIFO) to weighted-average cost for inventory From first-in, first-out (FIFO) to weighted-average cost for inventory Report as the last line item on the income statement, after extraordinary items, if any in arriving at net income Report as the last line item on the income statement, after extraordinary items, if any in arriving at net income

13 Earnings per Share (Net Income – Preferred Dividends) Earnings per Share of Common Stock ÷ Average Number of Common Shares Outstanding =

14 Earnings per Share of Common Stock Required to be disclosed on the income statement for all major sections 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 from exercise of: Earnings per share is subject to dilution (reduction), if issue of additional shares is possible in the future from exercise of: Convertible preferred stock Convertible preferred stock Convertible debentures (long-term debt) Convertible debentures (long-term debt) Stock options exercised Stock options exercised

15 Comprehensive Income Change in total stockholders’ equity from all sources other than from owners of the business (capital transactions): Change in total stockholders’ equity from all sources other than from owners of the business (capital transactions): Issuances of stock Issuances of stock payment of dividends payment of dividends Includes GAAP net income plus: Includes GAAP net income plus: unrealized gains (losses) on available-for-sale investments unrealized gains (losses) on available-for-sale investments foreign-currency translation adjustments 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

17 Learning Objective 2 Account for a corporation’s income taxes.

18 Accounting for Corporate Income Taxes Income tax expense – expense on income statement Income tax expense – expense on income statement Income tax payable – liability on balance sheet Income tax payable – liability on balance sheet

19 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 =×

20 Suppose for 20x5, Nike, Inc., has pretax accounting income of $900 million on the income statement, due to use of straight line depreciation for books. Suppose for 20x5, Nike, Inc., has pretax accounting income of $900 million on the income statement, due to use of straight line depreciation for books. Taxable income is $800 million on the company’s income tax return, due to use of double declining balanced appreciation for taxes. Taxable income is $800 million on the company’s income tax return, due to use of double declining balanced appreciation for taxes. This creates a difference between book income and taxable income (called deferred taxes) This creates a difference between book income and taxable income (called deferred taxes) Assume the tax rate is 40%. Assume 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

22 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

23 Corrections to the beginning balance of Retained Earnings for errors of a previous accounting period Corrections to the beginning balance of Retained Earnings for errors of a previous accounting 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

25 Restrictions on Retained Earnings Dividends and purchases of treasury stock constitute payments by the corporation to its stockholders Dividends and purchases of treasury stock constitute payments by the corporation to its stockholders Creditors may restrict a corporation’s dividend payments and treasury stock purchase activity: Creditors may restrict a corporation’s dividend payments and treasury stock purchase activity: legally, creditors have priority to corporate assets if there is a corporate dissolution legally, creditors have priority to corporate assets if there is a corporate dissolution Dividend and treasury stock purchases effectively circumvent creditor rights, conveying assets to stockholders that would otherwise be available to creditors Dividend and treasury stock purchases effectively circumvent creditor rights, conveying assets to stockholders that would otherwise be available to creditors Companies must report any retained earnings restrictions in notes to the financial statements Companies must report any retained earnings restrictions in notes to the financial statements

26 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

28 Analyzing the Statement of Stockholder’s Equity

29 Learning Objective 4 Understand managers’ and auditors’ responsibilities for the financial statements.

30 Responsibility for the Financial Statements Management of public companies Management of public companies Must issue statements of responsibility for the financial statements and entity systems of internal control in annual report filings to the SEC Must issue statements of responsibility for the financial statements and entity systems of internal control in annual report filings to the SEC These statements of responsibility declare: These statements of responsibility declare: Responsibility for the financial statements and states that the financial statements conform with GAAP (generally accepted accounting principles) Responsibility for the financial statements and states that the financial statements conform with GAAP (generally accepted accounting principles) That internal controls are suitably designed/implemented and are operating effectively That internal controls are suitably designed/implemented and are operating effectively Can go to jail for up to 25 years and be personally fined up to $5 million for knowingly misrepresenting these statements of responsibility, under the provisions of the Sarbanes-Oxley Act Can go to jail for up to 25 years and be personally fined up to $5 million for knowingly misrepresenting these statements of responsibility, under the provisions of the Sarbanes-Oxley Act

31 Auditor Report Typically contains three paragraphs: Introductory paragraph identifies the audited financial statements Introductory paragraph identifies the audited financial statements Scope paragraph generally describes how the audit was performed Scope paragraph generally describes how the audit was performed Opinion paragraph states the auditor’s opinion that the financial statements conform with GAAP in all material respectsand people can rely on them for decision making Opinion paragraph states the auditor’s opinion that the financial statements conform with GAAP in all material respectsand people can rely on them for decision making

32 Auditor Report Unqualified (Clean) opinion on the financial statements Unqualified (Clean) opinion on the financial statements Qualified opinion: the financial statements present fairly in all material respects, except for a material: Qualified opinion: the financial statements present fairly in all material respects, except for a material: GAAP departure GAAP departure Scope restriction, the effects of which could be material to the financial statements Scope restriction, the effects of which could be material to the financial statements Adverse: there is an extremely material GAAP departure Adverse: there is an extremely material GAAP departure Disclaimer caused by: Disclaimer caused by: A scope restriction, the effects of which could be extremely material to the financial statements, or A scope restriction, the effects of which could be extremely material to the financial statements, or The auditor lacks independence The auditor lacks independence