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4-1
1. The concept of income
2. Why income measure is important
3. How income is measured
4. The format of an income statement
5. The components of an income statement
6. The comprehensive income and statement of
stockholders’ equity
7. Simple forecasts of income for future periods
Chapter 4 Income Statement
4-2
What It Is and What It Isn’t
• Income is not equal to the amount of cash
generated from the successful operation of the
business.
• Income is a return over and above the
investment.
• It is the amount that an entity could return to
its investors and still leave the entity as well-
off at the end of the period as it was at the
beginning.
1. Define the concept of income
4-3
Financial Capital Maintenance Concept of
Income Determination
The financial capital maintenance concept
assumes that a company has income “only if
the dollar amount of an enterprise’s net
assets at the end of the period exceeds the
dollar amount of net assets at the beginning
of the period after excluding the effects of
transactions with owners.
(continued)
4-4
Beginning
of Period
End of
PeriodTotal assets $510,000 $560,000
Total liabilities 430,000 390,000
Net assets
(owners’ equity) $ 80,000 $170,000
Income is $90,000
Kreidler, Inc. had the following assets and
liabilities at the beginning and at the end of a
period.
(continued)
Financial Capital Maintenance Concept of
Income Determination
4-5
Net assets, end of period $170,000
Net assets, beginning of period 80,000
Change (increase) in net assets $ 90,000
Deduct investment by owners (40,000)
Add dividends to owners 15,000
Income $ 65,000
If the owners invested $40,000 in the business
and received dividends of $15,000, what would
be the income?
Financial Capital Maintenance Concept of
Income Determination
4-6
• Income per physical capital maintenance
occurs only if physical production capacity at
the end of the period exceeds the physical
production capacity at the beginning of the
period.
• This concept requires that productive assets
be valued at fair market value.
• Productive capital is maintained only if the
current costs of these capital assets are
maintained.
Physical Capital Maintenance Concept of
Income Determination
4-7
Practical Difficulties
a) Difficulty in estimating depreciation lives
b) Difficulty in implementing internal control
procedures
c) Difficulty in providing cash flow information
d) Difficulty in obtaining fair market values of
assets and liabilities
The FASB adopted the financial capital maintenance
concept as part of the conceptual framework.
Physical Capital Maintenance Concept of
Income Determination
4-8
Why is a Measure of Income Important?
The recognition, measurement, and reporting
(display) of business income and its
components are considered by many to be the
most important tasks of accountants. For
example:
• Has the activity been profitable?
• What is the trend of profitability?
• Is it increasing profitable, or is there a
downward trend?
2. Explain why an income measure is important
4-9
In the United States, the FASB has specified
that financial accounting information is
designed with investors and creditors in mind,
while at the same time recognizing that many
other groups will find the resulting information
useful as well.
Accrual-based financial accounting
information is not suited for every
possible use.
(continued)
Why is a Measure of Income Important?
4-10
• In code law countries, such as Germany and
Japan, accounting standards have
historically been set by legal processes.
• In a common law country, such as the United
States and the United Kingdom, accounting
standards are set in response to market
forces.
Why is a Measure of Income Important?
4-11
Transaction Approach
• To provide detail concerning the components of income, accountants have adopted a transaction approach to measuring income that stresses the direct computation of revenues and expenses.
• The transaction approach, sometimes referred to as the matching method, focuses on business events that effect certain elements of the financial statements.
2. Explain how income is measured, including
the revenue recognition and expense-
matching concepts
4-124-12
4-13
Revenue and Gain Recognition
• Under GAAP of accrual accounting, revenue
recognition does not necessarily occur when
cash is received.
• Revenues and gains are recognized when:
1. they are realized or realizable, and
2. they have been earned through substantial
completion of the activities involved in the
earnings process.
(continued)
4-14
Revenue and Gain Recognition
• Revenues are recognized when the company
generating the revenue has provided the bulk
of the goods or services it promised for the
customer and when the customer has provided
payment or at least a valid promise of payment
to the company.
• In order for revenue to be recognized,
inventory or other assets must be exchanged
for cash or claims to cash, such as accounts
receivable.
4-15
1. If a market exists for a product so that its sale
at an established price is practically ensured
without significant selling effort, revenue may
be recognized at the point of completed
production.
(continued)
Earlier Recognition
4-16
2. If a product or service is contracted for in
advance, revenue may be recognized as
production takes place, or as services are
performed, especially if the production or
performance period extends over more than
one fiscal year.
Earlier Recognition
4-17
Later Recognition
If collectability of assets received for products or
services is considered doubtful, revenues and
gains may be recognized as the cash is
received.
The installment sales and cost recovery
methods of accounting have been developed to
recognize revenue under these conditions.
Sales of real estate, especially speculative
recreational property, are often recorded using
this variation of the general rule.
4-18
Direct Matching
• Relating expenses to specific revenues is
often referred to as the matching process.
• For example, shipping costs and sales
commissions usually relate directly to
revenues.
• Certain expenses have to be estimated to be
matched against recognized revenue for the
period.
(continued)
Expense and Loss Recognition
4-19
• Direct expenses include not only those that
already have been incurred but also include
anticipated expenses related to revenues of
the current period.
• Costs of collection, bad debt losses from
uncollectible receivables, and possible
warranty costs should be estimated and
matched against recognized revenue for the
period.
Expense and Loss Recognition
4-20
Systematic and
Rational Allocation
The cost of assets that benefit more
than one period, such as buildings,
equipment, patents, and prepaid
insurance, are spread across the
periods of expected benefit in some
systematic and rational way.
Expense and Loss Recognition
4-21
Immediate Recognition
• Many expenses are not related to specific
revenues but are incurred to obtain goods
and services that indirectly help to
generate revenues.
• Examples include office salaries, utilities,
and general advertising. These are
recognized as expenses in the period in
which they are incurred.
Expense and Loss Recognition
4-22
Gains and Losses from Changes
in Market Values
• An exception to the transaction approach in
the recognition of gains and losses arises
when gains or loss are recognized in the
wake of changes in market value.
• When a long-term asset, such as a building,
has decreased substantially in value (an
impairment), a loss is recognized even
though the building has not been sold and no
transaction has occurred.
4-23
Form of the Income Statement
• Traditionally, the income from the continuing
operations category has been presented in
multiple-step form.
• Using this format, the income statement is
divided into separate sections, and various
subtotals reflect different levels of profitability.
(continued)
4. Understand the format of an income
statement
4-24(continued)
4-24
4-254-25
4-26
Techtronics Corporation
For discussion purposes, the multiple-step
income statement for Techtronics Corporation
will be used. This statement is shown in
Exhibit 4-6 on Slides 4-26 and 4-27.
(continued)
4-27(continued) 4-27
4-284-28
4-29
Form of the Income Statement
• Comparative financial statements
present several years’ financial statements
side by side. This enables users to analyze
performance over multiple periods and
identify significant trends.
• Consolidated financial statements
combine the financial results of the “parent
company” with other companies that it owns,
called subsidiaries.
4-30
Income from Continuing Operations
1. Revenue
2. Cost of goods sold
3. Operating expenses
4. Other revenues and gains
5. Other expenses and losses
6. Income taxes on continuing operations
(continued)
5. Describe the specific components of an
income statement
4-31
Gross profit =
(Revenue – Cost of goods sold)
Operating income =
(Gross profit – Operating expenses)
Determining Subtotals
(continued)
Income from Continuing Operations
4-32
Income from continuing operations before taxes
(Operating income + Other revenues and gains
– Other expenses and losses)
Income from continuing operations (Income from
continuing operations before income taxes –
Income taxes on continuing operations)
Determining Subtotals
(continued)
Income from Continuing Operations
4-33
Revenue
• Revenue reports the total sales to
customers for the period less any sales
returns and allowances or discounts.
• Sales returns and allowances and sales
discounts should be subtracted from gross
sales revenue in arriving at net sales
revenue.(continued)
Income from Continuing Operations
4-34
Cost of Goods Sold
Beginning inventory
+ Net purchases
+ Freight-in
+ Other inventory acquisition costs
= Cost of goods available for sale
– Ending inventory
= Cost of goods sold
(continued)
Income from Continuing Operations
4-35
• Cost of goods sold is a significant item on
merchandising and manufacturing companies’
income statements.
• A manufacturing company has three
inventories rather than one: raw materials,
goods in process, and finished goods.
Cost of Goods Sold
(continued)
Income from Continuing Operations
4-36
• Revenue from net sales – Cost of goods sold
= Gross profit
• Gross profit percentage is computed by
dividing gross profit by revenue from net
sales.
• The gross profit percentage provides a
measure of profitability that allows
comparisons for a firm from year to year.
Gross Profit
(continued)
Income from Continuing Operations
4-37
If a company is not generating enough from
the sale of a product or service to cover the
costs directly associated with that product or
service, the company will not be able to stay
in business for long.
(continued)
Income from Continuing Operations
4-38
Operating Expenses
Operating expenses may be reported in two
parts:
• Selling expenses
Sales salaries and commissions
Related payroll taxes
Advertising and store displays
Store supplies used
Depreciation on store furniture
(continued)
Income from Continuing Operations
4-39
• General and administrative expenses
Officers’ and office salaries
Related payroll taxes
Office supplies used
Telephone, business licenses, etc.
Depreciation on office furniture
(continued)
Income from Continuing Operations
4-40
Operating income measures the
performance of the fundamental business
operations conducted by a company.
Operating Income
Gross profit
– Operating expenses
= Operating income
(continued)
Income from Continuing Operations
4-41
This section usually includes items
identified with the peripheral activities of the
company:
• Rent revenue
• Interest revenue
• Dividend revenue
• Gains from the sale of assets
Other Revenues and Gains
(continued)
Income from Continuing Operations
4-42
This section parallels “Other Revenues and
Gains” except the items result in deductions
from operating income:
• Interest expense
• Losses from the sale of assets
(continued)
Other Expenses and Losses
Income from Continuing Operations
4-43
Income Taxes on Continuing
Operations
• Income tax expense is the sum of all the
income tax consequences of all transactions
undertaken by a company during a year.
• The separation of income taxes into different
sections of the income statement is referred
to as intraperiod income tax allocation.
(continued)
Income from Continuing Operations
4-44
Transitory, Irregular, and
Extraordinary Items
• These items arise from transactions and
events that are not expected to continue to
impact reported results in future years.
• Two types of transactions and events are
reported in this manner: (1) discontinued
operations and (2) extraordinary items.
Income from Continuing Operations
4-45
Discontinued Operations
• The operations and cash flows of the
component must be clearly distinguishable
from other operations and cash flows of the
company, both physically and operationally,
as well as for financial reporting purposes.
• For example, discontinued operations
would result if a company closed one of five
product lines in a plant which tracks its
cash flows and income separately.
To report discontinued operations:
(continued)
4-46
• The component may be unprofitable.
• The component may not fit into the long-
range plans for the company.
• Management may need funds to reduce
long-term debt or to expand into other areas.
• Management may be fearful of a corporate
takeover by new investors desiring to gain
control of the company.
Why Discontinue?
(continued)
4-47
• Thom Beard Company has two divisions, A
and B. The operations and cash flows of these
two divisions are clearly distinguishable, and
so they both qualify as business components.
• On June 20, 2013, Thom Beard decides to
dispose of the assets and liabilities of Division
B. The revenues and expenses for Thom
Beard for 2013 and for the preceding two
years are shown in Slide 4-48.
(continued)
Reporting Requirements for Discontinued
Operations
4-48
During the later part of 2013, Thom Beard
disposed of a portion of Division B and recognized
a pretax loss of $4,000 on the disposal. Assume a
tax rate of 40%. The comparative income
statements appear on Slide 4-49.
4-48(continued)
Reporting Requirements for Discontinued
Operations
4-494-49(continued)
Reporting Requirements for Discontinued
Operations
4-50
Discontinued Operations
• The reporting requirements for discontinued
operations are contained in FASB ASC Subtopic
205.
• On the balance sheet, assets and liabilities
associated with discontinued components that have
not been completely disposed of as of the balance
sheet date are to be listed separately in the asset
and liability sections of the balance sheet.
• In addition to the summary income or loss amount
reported in the income statement, the total revenue
associated with the discontinued operations should
be disclosed in the financial statement notes.
4-51
International Accounting for Discontinued
Operations
According to IFRS 5, companies with
discontinued operations must disclose the
following:
• The amount of revenue, expenses, and
pretax profit or loss attributed to the
discontinued operations and related income
tax expense.
• A separate disclosure of the assets, liabilities,
and cash flows of the discontinued
operations. (continued)
4-524-52
In complying with Financial Reporting Standard
(FRS) 3 of the Accounting Standards Board in
the United Kingdom, British Telecommunications
provided the following information in its 2002
profit and loss account (income statement).
International Accounting for Discontinued
Operations
4-53
Extraordinary Items
Extraordinary items are events and
transactions that are both unusual in nature
and infrequent in occurrence. Thus, they
must contain “a high degree of abnormality
and be of a type clearly unrelated to, or only
incidentally related to, the ordinary and
typical activities of the entity . . . [and] be of a
type that would not reasonably be expected
to recur in the foreseeable future. . .”¹ ¹Opinions of the Accounting Principles Board No. 30, “Reporting the
Results of Operations (NY: AICPA, 1973), par. 20.
(continued)
4-54
Not Extraordinary
• The write-down or write-off of receivables,
inventories, equipment leased to others, etc.
• The gains or losses from exchange or
remeasurement of foreign currencies
• The gains or losses on disposal of business
segment
• Other gains or losses from sale or abandonment
of productive assets
• The effects of a strike
• Adjustment of accruals on long-term contracts
(continued)
4-554-55
4-56
Changes in Accounting Principles
• The conditions of some occasions justify a
change from one accounting principle to another.
• Occasionally a company will change an
accounting principle because a change in
economic conditions suggests that an accounting
change will provide better information.
• More frequently, a change in accounting principle
occurs because the FASB issues a new
pronouncement requiring a change in principle.
• To improve compatibility, income statements for
all years presented must be restated using the
new accounting method.
4-57
Changes in Accounting Principles
In 2013, Brandoni Company decided to change its method
of computing cost of goods sold from FIFO to LIFO. The
following sales and cost of goods sold information are for
2011-2013.
The 2013 comparative income statements for Brandoni
Company are shown below.
4-58
Changes in Estimate
• In reporting periodic revenues and in
attempting to properly match those expenses
incurred to generate current-period revenues,
accountants must continually make judgments.
• Estimates are required for such factors as the
number of years of useful life for depreciable
assets, the amount of uncollectible accounts
expected, and the amount of warrant liability to
be recorded on the books.
• No retroactive adjustments.
(continued)
4-59
Changes in Estimate
• Springville Manufacturing Co. Inc.,
purchased a milling machine at a cost of
$100,000. It was estimated to have a useful
life of 10 years and no salvage value. The
company uses straight-line depreciation.
• At the beginning of the fifth year, conditions
indicated that the machine would be used
only three more years.
• The schedule on Slide 4-60 summarizes
the charges over the life of the asset.
(continued)
4-60
Changes in Estimate
4-61
Effects of Changing Prices
Accountants have traditionally ignored this
phenomenon, especially when gains would result
from recognition. McDonald’s used the following
approach in its 10-K filed with the SEC.
4-62
Net Income or Loss
Income or loss from continuing operations
combined with the results of discontinued
operations and extraordinary items provides a
summary measure of the firm’s performance
for a period: net income or net loss.
4-63
Return on Sales
In order to compare the period’s results with prior
periods or with the performance of other firms,
net income is divided by net sales to determine
the return on sales.
4-63
4-64
Earnings per share =
Income from continuing operations
Weighted average number of shares of
common stock outstanding
Earnings Per Share
• Earnings per share amounts are computed for
income from continuing operations and for each
unusual or extraordinary item.
• If necessary, companies display basic and diluted
earnings per share.
When presenting earnings-per-share figures:
4-65
The price-earnings (P/E) ratio expresses the
market value of common stock as a multiple of
earnings and allows investors to evaluate the
attractiveness of a firm’s common stock.
Market value per share
Earnings per shareP/E ratio =
(continued)
Price-Earnings (P/E) Ratio
4-664-66(continued)
4-67
In general, the following types of firms have higher
than average P/E ratios:
• Firms with strong future growth possibilities
• Firms with earnings for the year lower than
average because of a nonrecurring event
• Firms with substantial unrecorded assets
Price-Earnings (P/E) Ratio
In general, the following types of firms have lower
than average P/E ratios:
• Firms with earnings for the year higher than
average because of a nonrecurring event
• Firms perceived as being very risky
4-68
Comprehensive Income
• Comprehensive income is the number used to
reflect an overall measure of the change in a
company’s wealth during the period.
• In addition to net income, it includes items that
arise from changes in market conditions unrelated
to the business operations of a company.
• Most companies include a report of
comprehensive income as part of the statement of
stockholders’ equity.
6. Compute comprehensive income and
prepare a statement of stockholders’
equity.
4-69(continued) 4-69
4-70(continued) 4-70
4-71
(concluded)
4-71
4-72
Comprehensive Income
Three of the more common adjustments
made in arriving at comprehensive
income are:
• Foreign currency translation
adjustments
• Unrealized gains and losses on
available-for-sale securities
• Deferred gains and losses on
derivative financial instruments
4-73
Proposed New Income Statement Format
• FASB and the IASB are currently engaged in a
long-term project to restructure the way
information is presented in the financial
statements.
• The focus of this effort is to clearly separate
financial statement items that are related to a
company’s business activities from items that
are related to other activities such as income
taxes or financing.
(continued)
4-744-74(continued)
4-754-75
4-76
Forecasting Future Performance
• Financial statements report the past, but are
used to predict the future.
• Key to a good forecast involves identifying
factors that determine a certain level of revenue
or expense.
• Forecasting starts with a forecast for sales.
• It indicates how fast the company is expected to
grow and represents the general volume of
activity expected in the company.
7. Construct simple forecasts of income
for future periods
4-774-77
4-784-78
4-794-79