Presentation on theme: "The Income Statement, and Comprehensive Income."— Presentation transcript:
1 The Income Statement, and Comprehensive Income. Chapter 4Chapter 4: The Income Statement, Comprehensive Income, and the Statement of Cash FlowsThe purpose of the income statement is to summarize the profit‐generating activities that occurred during a particular reporting period. Comprehensive income includes net income as well as a few gains and losses that are not part of net income and are considered other comprehensive income items instead.The purpose of the statement of cash flows is to provide information about the cash receipts and cash disbursements of an enterprise that occurred during the period.This chapter has a twofold purpose: (1) to consider important issues dealing with the content, presentation, and disclosure of net income and other components of comprehensive income and (2) to provide an overview of the statement of cash flows, which is covered in depth in Chapter 21.
2 relationship to earnings quality. LEARNING OBJECTIVES1. Discuss the importance of income from continuing operations and describe its components.2. Describe earnings quality and how it is impacted by management practices to manipulate earnings.3. Discuss the components of operating and non-operating income and theirrelationship to earnings quality.4. Define what constitutes discontinued operations and describe the appropriate income statement presentation for these transactions.5. Define extraordinary items and describe the appropriate income statement presentation for these transactions.6. Define earnings per share (EPS) and explain required disclosures of EPS for certain income statement components.7. Explain the difference between net income and comprehensive income and how we report components of the difference.NOT COVERED8. Describe the purpose of the statement of cash flows.9. Identify and describe the various classifications of cash flows presented in a | statement of cash flows.10. Discuss the primary differences between U.S. GAAP and IFRS with respect to the income statement.
3 An income statement for a hypothetical manufacturing company that you can refer to as we proceed through the chapter.Before we discuss the specific components of an income statement in depth, let’s take a quick look at the general makeup of the statement. The graphic on this slide illustrates an income statement for a hypothetical manufacturing company that you can refer to as we proceed through the chapter. At this point, our objective is only to gain a general perspective of the items reported and classifications contained in corporate income statements. Notice the three general areas include income from continuing operations, separately reported items, and earnings per share.
4 Income from Continuing Operations RevenuesInflows of resources resulting from providing goods or services to customers.ExpensesOutflows of resources incurred in generating revenues.Gains and LossesIncreases or decreases in equity from peripheral or incidental transactions of an entity.Income Tax ExpenseBecause of its importance and size, income tax expense is a separate item.The need to provide information to help analysts predict future cash flows emphasizes the importance of properly reporting the amount of income from the entity’s continuing operations. Clearly, it is the operating transactions that probably will continue into the future that are the best predictors of future cash flows. The components of income from continuing operations are revenues, expenses (including income taxes), gains, and losses, excluding those related to discontinued operations and extraordinary items.Revenues are inflows of resources resulting from providing goods or services to customers, such as sales revenue.Expenses are outflows of resources incurred in generating revenues, such as cost of goods sold and operating expenses.Gains and losses are increases or decreases in equity from peripheral or incidental transactions of an entity. In general, these gains and losses are those changes in equity that do not result directly from operations but nonetheless are related to those activities. For example, gains and losses from the routine sale of equipment, buildings, or other operating assets and from the sale of investment assets normally would be included in income from continuing operations.Income tax expense is reported separately because of its importance and size.
5 Operating versus Nonoperating Income Includes revenues and expenses directly related to the principal revenue-generating activities of the companyIncludes certain gains and losses and revenues and expenses related to peripheral or incidental activities of the companyMany corporate income statements distinguish between operating income and nonoperating income. Operating income includes revenues and expenses directly related to the primary revenue-generating activities of the company. For example, operating income for a manufacturing company includes sales revenues from selling the products it manufactures as well as all expenses related to this activity. Similarly, operating income might also include gains and losses from selling equipment and other assets used in the manufacturing process.On the other hand, nonoperating income relates to peripheral or incidental activities of the company. For example, a manufacturer would include interest and dividend revenue, gains and losses from selling investments, and interest expense in nonoperating income. Other income (expense) often is the classification heading companies use in the income statement for nonoperating items. On the other hand, a financial institution like a bank would consider those items to be a part of operating income because they relate to the principal revenue generating activities for that type of business.
6 Income Stmt. (Single-Step) NOT COVERED Proper HeadingRevenues & GainsExpenses & LossesNo specific standards dictate how income from continuing operations must be displayed, so companies have considerable latitude in how they present the components of income from continuing operations. This flexibility has resulted in a variety of income statement presentations. However, we can identify two general approaches, the single-step and the multiple-step.This slide illustrates an example of a single-step income statement for a hypothetical manufacturing company, Maxwell Gear Corporation. The single-step format first lists all the revenues and gains included in income from continuing operations. Then, expenses and losses are grouped, subtotaled, and subtracted—in a single step—from revenues and gains to derive income from continuing operations. Operating and nonoperating items are not separately classified.
7 Income Statement (Multiple-Step) Proper HeadingGross ProfitOperating ExpensesNon- operating ItemsThe multiple-step income statement format includes a number of intermediate subtotals before arriving at income from operations. However, notice that the net income is the same no matter which format is used.A primary advantage of the multiple-step format is that, by separately classifying operating and nonoperating items, it provides information that might be useful in analyzing trends. Similarly, the classification of expenses by function also provides useful information.
8 Some differences are highlighted below. U. S. GAAP vs. IFRSThere are more similarities than differences between income statements prepared according to U.S. GAAP and those prepared applying IFRS.Some differences are highlighted below.Has no minimum requirements.SEC requires that expenses be classified by function.“Bottom line” called net income or net loss.Report extraordinary items separately.Specifies certain minimum information to be reported on the face of the income statement.Allows expenses classified by function or natural description.“Bottom line” called profit or loss.Prohibits reporting extraordinary items.There are more similarities than differences between income statements prepared according to U.S. GAAP and those prepared applying international standards. Some of the differences are:International standards require certain minimum information to be reported on the face of the income statement. U.S. GAAP has no minimum requirements.International standards allow expenses to be classified either by function (e.g., cost of goods sold, general and administrative, etc.), or by natural description (e.g., salaries, rent, etc.). SEC regulations require that expenses be classified by function.In the United States, the “bottom line” of the income statement usually is called either net income or net loss. The descriptive term for the bottom line of the income statement prepared according to international standards is either profit or loss.As we discuss later in the chapter, we report “extraordinary items” separately in an income statement prepared according to U.S. GAAP. International standards prohibit reporting “extraordinary items.”
9 Earnings QualityEarnings quality refers to the ability of reported earnings to predict a company’s future earnings.Transitory EarningsversusPermanent EarningsFinancial analysts are concerned with more than just the bottom line of the income statement—net income. The presentation of the components of net income and the related supplemental disclosures provide clues to the user of the statement in an assessment of earnings quality. Earnings quality is used as a framework for more in-depth discussions of operating and nonoperating income.Earnings quality refers to the ability of reported earnings to predict a company’s future earnings. The relevance of any historical-based financial statement hinges on its predictive value. To enhance predictive value, analysts try to separate a company’s transitory earnings effects from its permanent earnings. Transitory earnings effects result from transactions or events that are not likely to occur again in the foreseeable future, or that are likely to have a different impact on earnings in the future.
10 Manipulating Income and Income Smoothing “Most executives prefer to report earnings that follow a smooth, regular, upward path.”~Ford S. Worthy, “Manipulating Profits: How It’s Done,” FortuneTwo ways to manipulate income:Income shiftingIncome statement classificationAn often-debated contention is that, within GAAP, managers have the power, to a limited degree, to manipulate reported company income. And the manipulation is not always in the direction of higher income. In a Fortune article titled “Manipulating Profits: How It’s Done,” Ford S. Worthy states that “Most executives prefer to report earnings that follow a smooth, regular, upward path. They hate to report declines, but they also want to avoid increases that vary wildly from year to year; it’s better to have two years of 15% earnings increases than a 30% gain one year and none the next. As a result, some companies ‘bank’ earnings by understating them in particularly good years and use the banked profits to polish results in bad years.”How do managers manipulate income? Two major methods are (1) income shifting and (2) income statement classification.Income shifting is achieved by accelerating or delaying the recognition of revenues or expenses. For example, a practice called “channel stuffing” accelerates revenue recognition by persuading distributors to purchase more of your product than necessary near the end of a reporting period.The most common income statement classification manipulation involves the inclusion of recurring operating expenses in “special charge” categories such as restructuring costs. This practice sometimes is referred to as “big bath” accounting, a reference to cleaning up company balance sheets. Asset reductions, or the incurrence of liabilities, for these restructuring costs result in large reductions in income that might otherwise appear as normal operating expenses either in the current or future years.
11 Operating Income and Earnings Quality Restructuring CostsCosts associated with shutdown or relocation of facilities or downsizing of operations are recognized in the period incurred.Goodwill Impairment and Long-lived Asset ImpairmentInvolves asset impairment losses or charges.Should all items of revenue and expense included in operating income be considered indicative of a company’s permanent earnings? No. Operating expenses may include unusual items that may or may not continue in the future.Restructuring costs are recognized in the period the exit or disposal cost obligation actually is incurred. As an example, suppose terminated employees are to receive termination benefits, but only after they remain with the employer beyond a minimum retention period. In that case, a liability for termination benefits, and corresponding expense, should be accrued in the period(s) the employees render their service. On the other hand, if future service beyond a minimum retention period is not required, the liability and corresponding expense for benefits are recognized at the time the company communicates the arrangement to employees. In both cases, the liability and expense are recorded at the point they are deemed incurred. Similarly, costs associated with closing facilities and relocating employees are recognized when goods or services associated with those activities are received. GAAP also establishes that fair value is the objective for initial measurement of the liability, and that a liability’s fair value often will be measured by determining the present value of future estimated cash outflows.Goodwill impairment and long-lived asset impairment involves asset impairment losses or charges. Any long-lived asset, whether tangible or intangible, should have its balance reduced if there has been a significant impairment of value. We explore property, plant, and equipment and intangible assets in Chapters 10 and 11. After discussing this topic in more depth in those chapters, we revisit the concept of earnings quality as it relates to asset impairment.
12 Nonoperating Income and Earnings Quality Gains and losses generated from the sale of investments often can significantly inflate or deflate current earnings.Example As the stock market boom reached its height late in the year 2000, many companies recorded large gains from sale of investments that had appreciated significantly in value.How should those gains be interpreted in terms of their relationship to future earnings? Are they transitory or permanent?Most of the components of earnings in an income statement relate directly to the ordinary, continuing operations of the company. Some, though, such as interest and gains or losses are only tangentially related to normal operations. These we refer to as nonoperating items. Some nonoperating items have generated considerable discussion with respect to earnings quality, notably gains and losses generated from the sale of investments. For example, as the stock market boom reached its height late in the year 2000, many companies recorded large gains from the sale of investments that had appreciated significantly in value. How should those gains be interpreted in terms of their relationship to future earnings? Are they transitory or permanent?Companies often voluntarily provide a pro forma earnings number when they announce annual or quarterly earnings. Supposedly, these pro forma earnings numbers are management’s view of “permanent earnings,” in the sense of being a better long-run performance measure. These pro forma earnings numbers are controversial because determining which items to exclude is at the discretion of management. Therefore, management could mislead investors. Nevertheless, these disclosures do represent management’s perception of what its permanent earnings are and provides additional information to the financial community.
13 Separately Reported Items Reported separately, net of taxes:Discontinued operationsExtraordinary itemsGAAP requires that certain transactions be reported separately in the income statement, below income from continuing operations. There are two types of events that, if they have a material effect on the income statement, require separate reporting below income from continuing operations as well as separate disclosure: (1) discontinued operations and (2) extraordinary items. In fact, these are the only two events that are allowed to be reported below continuing operations. The presentation order is as shown on the slide. The objective is to separately report all the income effects of each of these items. The process of associating income tax effects with the income statement components that create them is referred to as intraperiod tax allocation, which we will address in the next section.
14 Intraperiod Income Tax Allocation Income Tax Expense must be associated with each component of income that causes it.Show Income Tax Expense related to Income from Continuing Operations.Report effects of Discontinued Operations and Extraordinary Items net of related income tax effect.Part IIntraperiod tax allocation associates (or allocates) income tax expense (or income tax benefits if there is a loss) with each major component of income that causes it. As a result, the two items reported separately below income from continuing operations are presented net of the related income tax effect. For example, assume a company experienced an extraordinary gain during the year. The amount of income tax expense deducted from income from continuing operations is the amount of income tax expense that the company would have incurred if there were no extraordinary gain. The effect on income taxes caused by the extraordinary item is deducted from the extraordinary gain in the income statement.Part IIAssume that the Maxwell Gear Corporation had income from continuing operations before income tax expense of $200,000 and an extraordinary gain of $60,000 in The income tax rate is 40% on all items of income or loss. Therefore, the company’s total income tax expense is $104,000 (40% × $260,000). However, as illustrated on this slide, the total tax expense of $104,000 must be allocated, $80,000 to continuing operations and $24,000 (40% × $60,000) to the extraordinary gain.
15 An extraordinary item is a material event or transaction that is both: Extraordinary ItemsAn extraordinary item is a material event or transaction that is both:Unusual in nature, andInfrequent in occurrenceExtraordinary items are reported net of related taxesExtraordinary items are material events and transactions that are both unusual in nature and infrequent in occurrence and are reported net of related tax effects. These criteria must be considered in light of the environment in which the entity operates. There is obviously a considerable degree of subjectivity involved in the determination. A key point in the definition of an extraordinary item is that determining whether an event satisfies both criteria depends on the environment in which the firm operates. The environment includes factors such as the type of products or services sold and the geographical location of the firm’s operations. What is extraordinary for one firm may not be extraordinary for another firm. For example, a loss caused by a tornado in Missouri may not be judged to be extraordinary. However, tornado damage in another state may indeed be unusual and infrequent.
16 the FASB to the elimination of the extraordinary item classification. U. S. GAAP vs. IFRSThe scarcity of extraordinary gains and losses reported in corporate income statements and the desire to converge U.S. and international accounting standards could guidethe FASB to the elimination of the extraordinary item classification.U.S. GAAP provides for the separate reporting, as an extraordinary item, of a material gain or loss that is unusual in nature and infrequent in occurrence. In 2003, the IASB revised IAS No. 1. The revision states that neither the income statement nor any notes may contain any items called “extraordinary.”A recent survey of 500 large public companies reported that only 24 of the companies disclosed an extraordinary gain or loss in their 2010 income statements. Losses from two 21st century “extraordinary” events, the September 11, 2001, terrorist attacks and Hurricane Katrina in 2005, did not qualify for extraordinary treatment. The treatment of these two events, the scarcity of extraordinary gains and losses reported in corporate income statements, and the desire to converge U.S. and international accounting standards could guide the FASB to the elimination of the extraordinary item classification.Report extraordinary items separately in the income statement.Prohibits reporting extraordinary items in the income statement or notes.
17 Unusual or Infrequent Items Items that are material and are either unusual or infrequent—but not both—are included as separate items in continuing operations.Items that are material and are either unusual or infrequent—but not both—are included as a separate item in continuing operations.
18 Discontinued Operations As part of the continuing process to converge U.S. GAAP and international standards, the FASB and IASB have been working together to develop a common definition and a common set of disclosures for discontinued operations.The proposed ASU defines a discontinued operation as a “component” that either (a) has been disposed of or (b) is classified as held for sale, and represents one of the following:a separate major line of business or major geographical area of operations,part of a single coordinated plan to dispose of a separate major line of business or geographical area of operations, ora business that meets the criteria to be classified as held for sale on acquisition.As part of the continuing process to converge U.S. GAAP and international standards, the FASB and IASB have been working together to develop a common definition and a common set of disclosures for discontinued operations. At the time this text was published, a final Accounting Standards Update had not been issued, but the two Boards had expressed a new direction in an Exposure Draft of a new ASU. The proposed ASU defines a discontinued operation as a “component” that either (a) has been disposed of or (b) is classified as held for sale, and represents one of the following:a separate major line of business or major geographical area of operations,part of a single coordinated plan to dispose of a separate major line of business or geographical area of operations, ora business that meets the criteria to be classified as held for sale on acquisition.Many were critical of prior guidance, feeling its definition of a component of the entity was too broad. In addition to achieving convergence with international standards, the new guidance is expected to reduce the number of business segments that require separate income statement presentation as a discontinued operation.
19 Reporting Discontinued Operations Reporting for Components SoldIncome or loss from operations of the component from the beginning of the reporting period to the disposal date.Gain or loss on the disposal of the component’s assets.Reporting for Components Held For SaleIncome or loss from operations of the component from the beginning of the reporting period to the end of the reporting period.An “impairment loss” if the carrying value of the assets of the component is more than the fair value minus cost to sell.When a component has been sold, the reported income effects of a discontinued operation will include two elements: (1) income or loss from operations of the component from the beginning of the reporting period to the disposal date and (2) gain or loss on the disposal of the component.When the component is considered held for sale, the reported income effects of a discontinued operation will include two elements: (1) income or loss from operations of the component from the beginning of the reporting period to the end of the reporting period and (2) an “impairment loss” if the carrying value of the assets of the component is more than the fair value minus cost to sell.
21 Earnings Per Share Disclosure One of the most widely used ratios is earnings per share (EPS), which shows the amount of income earned by a company expressed on a per share basis.Basic EPSNet income less preferred dividendsWeighted-average number of common shares outstanding for the periodDiluted EPSReflects the potential dilution that could occur for companies that have certain securities outstanding that are convertible into common shares or stock options that could create additional common shares if the options were exercised.One of the most widely used ratios is earnings per share, which shows the amount of income earned by a company expressed on a per share basis. Companies report both basic and diluted earnings per share.Basic earnings per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding.Diluted earnings per share reflects the potential for dilution that could occur for companies that have certain securities outstanding that are convertible into common shares or stock options that could create additional common shares if the options were exercised.
22 Earnings Per Share Disclosure Report EPS data separately for:Income or Loss from Continuing OperationsSeparately Reported Itemsdiscontinued operationsextraordinary ItemsNet Income or LossCompanies must disclose per share amounts for (1) income or loss before any separately reported items, (2) each separately reported item, and (3) net income or loss.
23 Comprehensive IncomeAn expanded version of income that includes four types of gains and losses that traditionally have not been included in income statements.Comprehensive income is the total change in equity for a reporting period other than from transactions with owners. Comprehensive income includes net income as well as other gains and losses that change shareholders’ equity but are not included in traditional net income.
24 Other Comprehensive Income (OCI) Comprehensive income includes traditional net income as well as four additional gains and losses that change shareholders’ equity.Changes in the market value of certain investments (described in chapter 12).Gains and losses due to revising assumptions or market returns differing from expectations and prior service cost from amending the plan (described in chapter 17).When a derivative designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction (described in the Derivatives Appendix to the text).Gains or losses from changes in foreign currency exchange rates. The amount could be an addition to or reduction in shareholders’ equity. (This item is discussed elsewhere in your accounting curriculum).The calculation of net income omits certain types of gains and losses that are included in comprehensive income. Companies must report both net income and comprehensive income and reconcile the difference between the two.The following items are part of comprehensive income:Changes in the market value of certain investments (described in chapter 12).Gains and losses due to revising assumptions or market returns differing from expectations and prior service cost from amending the plan (described in chapter 17).When a derivative designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction (described in the Derivatives Appendix to the text).Gains or losses from changes in foreign currency exchange rates. The amount could be an addition to or reduction in shareholders’ equity. (This item is discussed elsewhere in your accounting curriculum).
25 Other Comprehensive Income Companies must report both net income and comprehensive income and reconcile the difference between the two. Be sure to remember that net income actually is a part of comprehensive income. The information in the income statement and other comprehensive income items can be presented either (1) in a single, continuous statement of comprehensive income or (2) in two separate, but consecutive statements, an income statement and a statement of comprehensive income.
26 U. S. GAAP vs. IFRSBoth U.S. GAAP and IFRS allow companies to report comprehensive income in either a single statement of comprehensive income or in two separate statements. Other comprehensive income items are similar under the two sets of standards.Includes four possible Other Comprehensive Income items.Both U.S. GAAP and IFRS allow companies to report comprehensive income in either a single statement of comprehensive income or in two separate statements. Other comprehensive income items are similar under the two sets of standards.However, an additional OCI item, changes in revaluation surplus, is possible under IFRS. In Chapter 10 you will learn that IAS No. 16 permits companies to value property, plant, and equipment at (1) cost less accumulated depreciation or (2) fair value (revaluation). IAS No. 38 provides a similar option for the valuation of intangible assets. U.S. GAAP prohibits revaluation.If the revaluation option is chosen and fair value is higher than book value, the difference, changes in revaluation surplus, is reported as other comprehensive income and then accumulates in a revaluation surplus account in equity.Includes same four.Includes a fifth possible item, changes in revaluation surplus, from the optional revaluation of property, plant, and equipment and intangible assets.
27 Accumulated Other Comprehensive Income In addition to reporting comprehensive income that occurs in the current period, we must also report these amounts on a cumulative basis in the balance sheet as an additional component of shareholders’ equity.In addition to reporting OCI that occurs in the current reporting period, we must also report these amounts on a cumulative basis in the balance sheet. This is consistent with the way we report net income that occurs in the current reporting period in the income statement and also report accumulated net income (that hasn’t been distributed as dividends) in the balance sheet as retained earnings. Similarly, we report OCI as it occurs in the current reporting period and also report accumulated other comprehensive income (AOCI) in the balance sheet. This is demonstrated on this slide for Astro-Med Inc.