1. The Income Statement, Comprehensive Income, and the Statement of Cash Flows
Chapter 4
Chapter 4: The Income Statement, Comprehensive Income, and the Statement of Cash Flows
The 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. 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.

3. Income from Continuing Operations
Revenues
Inflows of resources resulting from providing goods or services to customers.
Expenses
Outflows of resources incurred in generating revenues.
Gains and Losses
Increases or decreases in equity from peripheral or incidental transactions of an entity.
Income Tax Expense
Because 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.

4. Operating versus Nonoperating Income
Includes revenues and expenses directly related to the principal revenue-generating activities of the company
Includes certain gains and losses and revenues and expenses related to peripheral or incidental activities of the company
Many 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.

5. Earnings Quality
Earnings quality refers to the ability of reported earnings to predict a company’s future earnings.
Transitory Earnings
versus
Permanent Earnings
Financial 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.

6. Separately Reported Items
Reported separately, net of taxes:
Discontinued operations
Extraordinary items
GAAP 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.

7. 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 I
Intraperiod 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 II
Assume 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.

8. Reporting Discontinued Operations
Reporting for Components Sold
Income 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 Sale
Income 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.

9. An extraordinary item is a material event or transaction that is both:
Extraordinary Items
An extraordinary item is a material event or transaction that is both:
Unusual in nature, and
Infrequent in occurrence
Extraordinary items are reported net of related taxes
Extraordinary 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.

10. 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.

11. Accounting Changes
Accounting changes fall into one of three categories: (1) a change in an accounting principle, (2) a change in an accounting estimate, or (3) a change in reporting entity. The correction of an error is another adjustment that is accounted for in the same way as certain accounting changes. A brief overview of a change in accounting principle, a change in estimate, and correction of errors is provided here. We cover accounting changes in detail, including changes in reporting entities, in subsequent chapters, principally in Chapter 20.

12. Correction of Accounting Errors
Errors occur when transactions are either recorded incorrectly or not recorded at all.
Errors Discovered in Same Year
Reverse original erroneous journal entry and record the appropriate journal entry.
Record a prior period adjustment to the beginning retained earnings balance in a statement of shareholders’ equity.
Previous years’ financial statements that are incorrect as a result of the error are retrospectively restated to reflect the correction.
Material Errors Discovered in Subsequent Year
Errors occur when transactions are either recorded incorrectly or not recorded at all. Accountants employ various control mechanisms to ensure that transactions are accounted for correctly. In spite of this, errors occur. When errors do occur, they can affect any one or several of the financial statement elements on any of the financial statements a company prepares. In fact, many kinds of errors simultaneously affect more than one financial statement. When errors are discovered, they should be corrected.
Most errors are discovered in the same year that they are made. These errors are simple to correct. The original erroneous journal entry is reversed and the appropriate entry is recorded.
If an error is discovered in a year subsequent to the year the error is made, the accounting treatment depends on whether or not the error is material with respect to its effect on the financial statements. In practice, the vast majority of errors are not material and are, therefore, simply corrected in the year discovered. However, material errors that are discovered in subsequent periods require a prior period adjustment. In addition to reporting the prior period adjustment to retained earnings, previous years’ financial statements that are incorrect as a result of the error are retrospectively restated to reflect the correction. Also, a disclosure note communicates the impact of the error on prior periods’ net income.

13. 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 EPS
Net income less preferred dividends
Weighted-average number of common shares outstanding for the period
Diluted EPS
Reflects 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.

14. Earnings Per Share Disclosure
Report EPS data separately for:
Income or Loss from Continuing Operations
Separately Reported Items
discontinued operations
extraordinary Items
Net Income or Loss
Companies 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.

15. Comprehensive Income
An 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.

16. The Statement of Cash Flows
Provides relevant information about a company’s cash receipts and cash disbursements.
Helps investors and creditors to assess
future net cash flows
liquidity
long-term solvency.
Required for each income statement period reported.
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 a period. The statement of cash flows helps investors and creditors assess future net cash flows, liquidity, and long-term solvency. A statement of cash flows is required for each income statement period reported.

17. Cash Flows from Operating Activities
Inflows from:
sales to customers.
interest and dividends received. +
Cash Flows from Operating Activities
Outflows for:
purchase of inventory.
salaries, wages, and other operating expenses.
interest on debt.
income taxes. _
Operating activities are inflows and outflows of cash related to the transactions entering into the determination of net operating income. A few examples of cash inflows and outflows from operating activities are listed on this slide. The difference between the inflows and the outflows is called net cash flows from operating activities. This is equivalent to net income if the income statement had been prepared on a cash basis rather than an accrual basis.

18. Direct and Indirect Methods of Reporting
Two Formats for Reporting Operating Activities
Reports the cash effects of each operating activity
Direct Method
Starts with accrual net income and converts to cash basis
Indirect Method
Two generally accepted formats can be used to report operating activities, the direct method and the indirect method.
Under the direct method, the cash effect of each operating activity is reported directly in the statement of cash flows. Under the indirect method, cash flow from operating activities is derived indirectly by starting with reported net income and adding or subtracting items to convert that amount to a cash basis.

19. Cash Flows from Investing Activities
Inflows from:
sale of long-lived assets used in the business.
sale of investment securities (stocks and bonds).
collection of nontrade receivables. +
Cash Flows from Investing Activities _
Outflows for:
purchase of long-lived assets used in the business.
purchase of investment securities (stocks and bonds).
loans to other entities.
Investing activities involve the acquisition and sale of (1) long-lived assets used in the business and (2) nonoperating investment assets. A few examples of cash inflows and outflows from investing activities are listed on this slide. The investing section of the statement of cash flows is the same whether the direct or indirect method is used for preparation of the statement of cash flows.

20. Cash Flows from Financing Activities
Inflows from:
sale of shares to owners.
borrowing from creditors through notes, loans, mortgages, and bonds.
Cash Flows from Financing Activities +
Outflows for:
owners in the form of dividends or other distributions.
owners for the reacquisition of shares previously sold.
creditors as repayment of the principal amounts of debt. _
Financing activities involve cash inflows and outflows from transactions with creditors and owners. A few examples of cash inflows and outflows from financing activities are listed on this slide. The financing section of the statement of cash flows is the same whether the direct or indirect method is used for preparation of the statement of cash flows.

21. Noncash Investing and Financing Activities
Significant investing and financing transactions not involving cash also are reported.
Acquisition of equipment (an investing activity) by issuing a long-term note payable (a financing activity).
As we just discussed, the statement of cash flows provides useful information about the investing and financing activities in which a company is engaged. Even though these primarily result in cash inflows and cash outflows, there may be significant investing and financing activities occurring during the period that do not involve cash flows at all. In order to provide complete information about these activities, any significant noncash investing and financing activities (that is, noncash exchanges) are reported either on the face of the statement of cash flows or in a disclosure note. An example of a significant noncash investing and financing activity is the acquisition of equipment (an investing activity) by issuing either a long-term note payable or equity securities (a financing activity).

22. End of Chapter 4
End of Chapter 4.