Chapter 11
The Income Statement & The Statement of Stockholders’ Equity
Learning Objectives
Analyze a complex income statement Account for a corporation’s income tax Analyze a statement of stockholders’
equity Understand managers’ and auditors’
responsibilities for the financial statements
Income Statement
Periodically Prepared to report Financial Consequences of Activities Undertaken– By Accounting Entity– Within a Certain Period of Time
Profit– More resources available at end-of-period then
beginning-of-period Loss
– Consumed more resources by the end-of-period then it generated
Income Statement
Summary of Revenues and Expenses
For a Specific Period of Time Grouped by Class
– Sales Returns and Allowances Discounts
– Cost of Goods Sold– Gross Margin/Profit– Operating Expenses
Selling Expenses– Salaries– Advertising– Travel– Telephone– Supplies– Depreciation
– Administrative Salaries Telephone Legal & Professional Supplies Depreciation – Bldg & Equip Misc.
– Net Income from Operations– Other
Interest Expense Interest Income
– Discontinued Operations– Extraordinary Events– Cumulative Effect of Change– Net Income– Earnings Per Share
Accounting Principles
Matching Revenue Realization
Income Statement - Continuing Operations
Allied Electronics CorporationIncome Statement
Year Ended December 31, 20x5
Sales revenue $500,000Cost of goods sold –240,000Gross margin $260,000Operating expenses 181,000Operating income $ 79,000
Operating income $79,000Other gains (losses):Loss on restructuring operations ( 8,000)Gain on sale of machinery 19,000
Income from continuing operationsbefore income tax $90,000
Income tax expense 36,000Income from continuing operations $54,000
Income Statement - Continuing Operations
Discontinued operations: $35,000,less income tax of $14,000 21,000
Income before extraordinary itemsand cumulative effect of changein depreciation method $75,000
Extraordinary flood loss, $20,000,less income tax savings of $8,000 (12,000)
Cumulative effect of change indepreciation method, $10,000,less income tax of $4,000 6,000
Net income $69,000
Income Statement - Special Items
Income from Continuing Operations
A measure of the part of the business expected to be ongoing.
Used to predict future income.
Predicting Future Profits
Estimated value ofCommon Stock =
Estimated annualincome in the future
Investmentcapitalization rate
If estimated value of the company:
Decision
Exceeds Current marketValue of the
Company
Buy the stockEquals Hold the stockIs less than Sell the stock
Estimated Value of Common Stock
Cap Rate Est Value Mke ValueOperating Income 79,000 0.12 658,333 513,000 Income from Continuting Opeations 54,000 0.12 450,000 513,000
Market Value Common Shares Outstanding 108,000 Market Price per share 4.75
513,000
Continuing Operations
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
Other Income Statement Items
Discontinued Operations Extraordinary Gains and Losses
(Extraordinary Items)– Must be both infrequent
seldom happening or occurring – and Unusual
not ordinarily encountered Cumulative Effect of a Change in Accounting
Method
Discontinued Operations
Segment – identifiable division of a company– Sold or– Closed
Extraordinary Items
Unusual for the company and infrequent– Losses due to natural disasters– Expropriations
the action of the state in taking or modifying the property rights of an individual in the exercise of its sovereignty
An Exception– Material gains/losses from extinguishment of debt
(to be reported as extraordinary item)
Cumulative Effect of a Change in Accounting Principle
From double-declining-balance (DBB) to straight-line depreciation
From first-in, first-out (FIFO) to weighted-average cost for inventory
Report in a special section of the income statement after extraordinary items
Earnings Per ShareEarnings per share =
Net Income - Preferred dividends
Average number of shares of common outstanding
• Earnings per share is disclosed separately for:– continuing operations– discontinued operations (do not subtract pfd)– Extraordinary items (don not subtract pfd)– Cumulative effect of change in accounting
method (do not subtract pfd)
Earnings per share of common stock(20,000 shares outstanding):
Income from continuous operations(54000)/20000 $2.70Income from discontinued operations(21000/20000) 1.05Income before extraordinary item and cumulative effect of change in depreciation method(75000/20000) $3.75Extraordinary loss(12000/20000) (0.60)Cumulative effect of change in depreciation method(6000/20000) 0.30
Net income(69000/20000) $3.45
Income Statement - Earnings per Share
Earnings Per Share
Effect of preferred stock– preferred dividends must be paid before
distributions of earnings to common stockholders.
Dilution– Convertible items could result in diluted eps.– Diluted EPS is disclosed on the income
statement.
Comprehensive Income
Change in total stockholders’ equity from all sources other than from the owners of the business.– Unrealized gains (losses) on available-for-
sale investments– Foreign-currency translation adjustments
Corporate Income Taxes• Must measure
– Income tax expense– Income tax payable
Incometax
expense=
Income before income tax (from the
income statement)X
IncomeTax Rate
Incometax
payable
=Taxable income from the income tax return
filed with the IRSX Income
Tax Rate
Corporate Income Taxes
Difference between income tax expense and income tax payable is a deferred tax liability or deferred tax asset.
Suppose for 20x5, Nike, Inc., has pretax accounting income of $900 million on the income statement.
Taxable income is $800 million on the company’s income tax return.
The tax rate is 40%.
Accounting for CorporateIncome Taxes
Accounting for CorporateIncome Taxes
General Journal
Date Accounts and Explanations PR Debit Credit
Dec 31 Income Tax Expense ($900 x .40) 360 Income Tax Payable ($800 x .40) 320 Deferred Tax Liability 40Recorded income tax for the year
©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Income statementIncome before income tax $900Income tax expense 360Net income $540
Balance sheetCurrent Liabilities: Income tax payable $320Long-term liabilities: Deferred tax liability 40*Total $360
*Assumes beginning tax liability was zero.
Accounting for CorporateIncome Taxes
Retained Earnings
Prior period adjustments– corrections of errors that occurred in prior
periods. Since the temporary accounts have
been closed to retained earnings, errors from prior periods must be made to retained earnings.
CNN CorporationStatement of Retained EarningsYear Ended December 31, 2005
Retained Earnings, Dec. 31, 2004 (original) $390,000Prior-period adjustment – debit to correct error in recording income tax expense of 2004 ( 10,000)Retained earnings, Dec. 31, 2004, adjusted $380,000Net income for 2005 114,000Total $494,000Deduct: 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
Restrictions on Retained Earnings
Dividends and purchases of treasury stock require payments by the corporation to its stockholders
Creditors may restrict a corporation’s dividend payments and treasury stock purchases
Companies report any retained earnings restrictions in notes to the financial statements
Statement of Stockholders’ Equity
Reports all changes in equity for the period. Issuance of stock Net income Cash dividends Stock dividends Treasury stock transactions Accumulated other comprehensive income
Accumulated Other
Comprehensive Income
Common Stock $1 Par
Additional Paid-in Capital
Retained Earnings
Treasury Stock
Unrealized Gain
(loss) on Investments
Foreign- Currency
Translation Adjustment
Total Stockholders’
Equity
Balance, Dec 31, 20X4 $80,000 $160,000 $130,000 $(25,000) $6,000 $(10,000) $341,000 Issuance of stock 20,000 65,000 85,000
Net Income 69,000 69,000 Cash Dividends (21,000) (21,000)
Stock dividends – 8% 8,000 26,000 (34,0000 -0- Purchase of Treasury Stock (9,000) (9,000)
Sale of Treasury Stock 7,000 4,000 11,000 Unrealized gain on investments 1,000 1,000
Foreign-currency translation adjustment
3,000 3,000
Balance, Dec 31, 20X5 $108,000 $258,000 $144,000 $(30,000) $7,000 $ (7,000) $480,000
Statement of Stockholders’ Equity
Responsibility for theFinancial Statements
Management – issues a statement of responsibility with
financial statements– declares responsibility for financial
statements and states that they conform to GAAP
Auditor Report
Typically contains three paragraphs: Identifies the audited financial statements Describes how the audit was performed States the auditor’s opinion -financial
statements conform to GAAP and people can rely on them for decision making
Auditor Report
Unqualified (Clean)– the financial statements presented are free of material
misstatements and are in accordance with GAAP Qualified
– the financial statements are fairly presented with a certain exception which is otherwise misstated
Adverse– the information contained is materially incorrect, unreliable, and
inaccurate in order to assess the auditee’s financial position and results of operations
Disclaimer– the auditor could not form, and consequently refuses to present, an
opinion on the financial statements