5-1
CHAPTER 5
Income Statement and Related Information
ASSIGNMENT CLASSIFICATION TABLE
Topics Questions
Brief
Exercises Exercises Problems Cases
1. Income measurement
concepts.
1, 2, 3, 4, 5,
6, 7, 8, 9, 10,
12, 13, 18,
20, 28, 31,
32, 33
3, 5, 6, 7,
9
2. Computation of net
income from balance
sheets and selected
accounts.
1 1, 2, 7
3. Single-step income
statements; earnings
per share.
11, 23, 24 2, 8 3, 4, 5, 6, 7,
10, 15, 16
2, 3, 4, 5 1, 9
4. Multiple-step income
statements.
17 3 4, 5, 6, 8, 11 1, 4
5. Extraordinary items;
accounting changes;
discontinued
operations; prior
period adjustments;
errors.
14, 15, 16,
27, 29
4, 5, 6, 7 9, 10, 11,
12, 13
3, 4, 5, 6,
7, 8
4, 7, 8,
10
6. Retained earnings
statement.
30 9, 10 10, 11, 12,
16
1, 2, 4, 5,
6, 7
7. Intraperiod tax
allocation.
21, 22, 25,
26, 27
8. Comprehensive
income.
34 11 14, 15, 16 11
9. Disposal of a
component (discon-
tinued operations).
35
5-2
ASSIGNMENT CHARACTERISTICS TABLE
Item Description
Level of
Difficulty
Time
(minutes)
E5-1 Computation of net income. Simple 18-20
E5-2 Income statement items. Simple 25-35
E5-3 Single-step income statement. Moderate 20-25
E5-4 Multiple-step and single-step. Simple 30-35
E5-5 Multiple-step and extraordinary items. Moderate 30-35
E5-6 Multiple-step and single-step. Moderate 30-40
E5-7 Compute Income, EPS. Simple 15-20
E5-8 Multiple-step statement with retained earnings. Simple 30-35
E5-9 Earnings per share. Simple 20-25
E5-10 Condensed income statement—periodic inventory
method.
Moderate 20-25
E5-11 Retained earnings statement. Simple 20-25
E5-12 Earnings per share. Moderate 15-20
E5-13 Change in accounting principle—depreciation. Moderate 15-20
E5-14 Comprehensive income. Simple 15-20
E5-15 Comprehensive income. Moderate 15-20
E5-16 Single step statement, retained earnings statement,
comprehensive income.
Moderate 30-35
P5-1 Multi-step income, retained earnings. Moderate 30-35
P5-2 Single-step income, retained earnings—periodic
inventory.
Simple 25-30
P5-3 Irregular items. Moderate 30-40
P5-4 Multi- and single-step income, retained earnings. Moderate 45-55
P5-5 Irregular items. Moderate 20-25
P5-6 Retained earnings statement, prior period adjustments. Moderate 25-35
P5-7 Income statement and irregular items. Complex 40-50
P5-8 Income statement and irregular items. Moderate 25-35
C5-1 Identification of income statement deficiencies. Simple 20-25
C5-2 Identify income statement deficiencies. Simple 10-15
C5-3 All-inclusive vs. current operating. Moderate 25-35
C5-4 Extraordinary items. Moderate 20-25
C5-5 Earnings management—ethical issues. Moderate 20-25
C5-6 Earnings management Simple 15-20
C5-7 Income reporting items. Simple 25-30
C5-8 Identification of extraordinary items. Moderate 30-35
C5-9 Identification of income statement weaknesses. Moderate 30-40
C5-10 Classification of income statement items. Moderate 20-25
C5-11 Comprehensive income. Simple 10-15
5-3
ANSWERS TO QUESTIONS
1. The income statement is important because it provides investors and creditors with information
that helps them predict the amount, timing, and uncertainty of future cash flows. It helps
investors and creditors predict future cash flows in a number of different ways. First, investors
and creditors can use the information on the income statement to evaluate the past
performance of the enterprise. Second, the income statement helps users of the financial
statements to determine the risk (level of uncertainty) of income–revenues, expenses, gains,
and losses–and highlights the relationship among these various components.
It should be emphasized that the income statement is used by parties other than investors and
creditors. For example, customers can use the income statement to determine a company’s
ability to provide needed goods or services, unions examine earnings closely as a basis for
salary discussions, and the government uses the income statements of companies as a basis
for formulating tax and economic policy.
2. Information on past transactions can be used to identify important trends that, if continued,
provide information about future performance. If a reasonable correlation exists between past
and future performance, predictions about future earnings and cash flows can be made. For
example, a loan analyst can develop a prediction of future performance by estimating the rate
of growth of past income over the past several periods and project this into the next period.
Additional information about current economic and industry factors can be used to adjust the
trend rate based on historical information.
3. Some situations in which changes in value are not recorded in income are:
a) Unrealized gains or losses on investments,
b) Changes in the market values of long term liabilities, such as bonds payable,
c) Changes in value of property, plant and equipment, such as land, natural resources, or
equipment,
d) Changes in the values of intangible assets such as customer goodwill, brand value, or
intellectual capital.
Note that some of these omissions arise because the items (e.g., brand value) are not
recognized in financial statements, while others (value of land) are recorded in financial
statements but measurement is at historical cost.
4. Some situations in which application of different methods or estimates lead to comparison
problems include:
a. Inventory methods – LIFO vs. FIFO,
b. Depreciation Methods – Straight-line vs. accelerated,
c. Accounting for long-term contracts – percentage of completion vs. completed contract,
d. Estimates of useful lives or salvage values for depreciable assets,
e. Estimated of bad debts,
f. Estimates of warranty returns.
5. The transaction approach focuses on the activities that have occurred during a given period
and instead of presenting only a net change, a description of the components that comprise the
change is included. In the capital maintenance approach, therefore, only the net change
(income) is reflected whereas the transaction approach not only provides the net change
(income) but the components of income (revenues and expenses). The final net income figure
should be the same under either approach given the same valuation base.
5-4
Questions Chapter 5 (Continued)
6. Earnings management is often defined as the planned timing of revenues, expenses, gains and
losses to smooth out bumps in earnings. In most cases, earnings management is used to
increase income in the current year at the expense of income in future years. For example,
companies prematurely recognize sales before they are complete in order to boost earnings.
Earnings management can also be used to decrease current earnings in order to increase
income in the future. The classic case is the use of “cookie jar” reserves, which are
established, by using unrealistic assumptions to estimate liabilities for such items as sales
returns, loan losses, and warranty returns.
7. Earnings management has a negative effect on the quality of earnings if it distorts the
information in a way that is less useful for predicting future cash flows. Within the Conceptual
Framework, useful information is both relevant and reliable. However, earnings management
reduces the reliability of income, because the income measure is biased (up or down) and/or
the reported income that is not representationally faithful to that which it is supposed to report
(e.g., volatile earnings are made to look more smooth).
8. Caution should be exercised because many assumptions and estimates are made in
accounting and the income figure is a reflection of these assumptions. If for any reason the
assumptions are not well-founded, distortions will appear in the income reported. The
objectives of the application of generally accepted accounting principles to the income
statement are to measure and report the results of operations as they occur for a specified
period without recognizing any artificial exclusions or modifications.
9. The term “quality of earnings” refers to the credibility of the earnings number reported.
Companies that use aggressive accounting policies report higher income numbers in the short-
run. In such cases, we say that the quality of earnings is low. Similarly, if higher expenses are
recorded in the current period, in order to report higher income in the future, then the quality of
earnings is considered low.
10. The major distinction between revenues and gains (or expenses and losses) depends on the
typical activities of the enterprise. Revenues can occur from a variety of different sources, but
these sources constitute the entity’s ongoing major or central operations. Gains also can arise
from many different sources, but these sources occur from peripheral or incidental transactions
of an entity. The same type of distinction is made between an expense and a loss.
11. The advantages of the single-step income statement are: (1) simplicity and conciseness, (2)
probably better understood by the layperson, (3) emphasis on total costs and expenses, and
net income, and (4) does not imply priority of one revenue or expense over another. The
disadvantages are that it does not show the relationship between sales and cost of goods sold
and it does not show other important relationships and information, such as income from
operations, income before taxes, etc.
12. Operating items are the expenses and revenues which relate directly to the principal activity of
the concern; they are revenues realized from, or expenses which contribute to, the sale of
goods or services for which the company was organized. The nonoperating items result from
secondary activities of the company. They are not directly related to the principal activity of the
company but arise from subsidiary activities.
5-5
Questions Chapter 5(Continued)
13. The current operating performance income statement contains only the revenues and usual
expenses of the current year, with all unusual gains or losses or material corrections of prior
periods’ revenues and expenses appearing in the retained earnings statement. The all-
inclusive income statement includes all items of income and expense and gains and losses
recognized in the accounts during the year. The retained earnings statement then would
include only the beginning balance, the net amount transferred from income summary,
dividends, and transfers to and from appropriations.
In APB Opinion No. 9, the APB recommended a modified all-inclusive income statement,
excluding from the income statement only those items, few in number, which meet the criteria
for prior period adjustments and which would thus appear as adjustments to the beginning
balance in the retained earnings statement. Subsequently a number of pronouncements have
reinforced this position.
14. Items that are considered prior period adjustments should be charged or credited to the
opening balance of retained earnings. Prior period adjustments would ordinarily be either
corrections of errors made in a prior period discovered after issuance of financial statements for
that period or retroactive adjustments required or permitted by an FASB Statement or APB
Opinion.
15. (a) This might be shown in the income statement as an extraordinary item if it is a material,
unusual, and infrequent gain realized during the year. However, in general and in accord
with APB Opinion No. 30, this transaction would normally not be considered
extraordinary, but would be shown in the nonoperating section of a multiple-step income
statement. If unusual or infrequent but not both, it should be separately disclosed in the
income statement.
(b) The bonus should be shown as an operating expense in the income statement. Although
the basis of computation is a percentage of net income, it is an ordinary operating
expense to the company and represents a cost of the service received from employees.
(c) If the amount is immaterial, it may be combined with the depreciation expense for the year
and included as a part of the depreciation expense appearing in the income statement. If
the amount is material, it should be shown in the retained earnings statement as an
adjustment to the beginning balance of retained earnings, treated as a prior period
adjustment.
(d) This should be shown in the income statement. One treatment would be to show it in the
statement as a deduction from the rent expense, as it reduces an operating expense and
therefore is directly related to operations. Another treatment is to show it in the other
revenues and gains section of the income statement.
(e) Assuming that a provision for the loss had not been made at the time the patent
infringement suit was instituted, the loss should be recognized in the current period in
computing net income. It may be reported as an unusual loss.
(f) This should be reported in the income statement, but not as an extraordinary item
because it relates to usual business operations of the firm.
5-6
Questions Chapter 5 (Continued)
16. (a) The remaining book value of the equipment should be depreciated over the remainder of
the five-year period. The additional depreciation ($425,000) is not a correction of an error
and is not shown as an adjustment to retained earnings.
(b) The loss should be shown as an extraordinary item, assuming that it is unusual and
infrequent.
(c) Should be shown either as other expenses or losses or in a separate section,
appropriately labeled as an unusual item, if unusual or infrequent but not both. It should
not be shown as an extraordinary item.
(d) Assuming that a receivable had not been recorded in the previous period, the gain should
be recognized in the current period in computing net income, but not as an extraordinary
item.
(e) A correction of error should be considered a prior period adjustment and the beginning
balance of Retained Earnings should be restated.
(f) The cumulative effect of $925,000 should be separately reported between extraordinary
items and net income.
17. (a) Other expenses or losses section or in separate section, appropriately labeled as an
unusual item, if unusual or infrequent but not both.
(b) Operating expense section or other expenses and losses section or in separate section,
appropriately labeled as an unusual item, if unusual or infrequent but not both. APB
Opinion No. 30 specifically states that the effect of a strike does not constitute an
extraordinary item.
(c) Operating expense section, as a selling expense, but sometimes reflected as an
administrative expense.
(d) Separate section after income from continuing operations, entitled discontinued
operations.
(e) Other revenues and gains section or in a separate section, appropriately labeled as an
unusual item, if unusual or infrequent but not both.
(f) Other revenues and gains section.
(g) Operating expense section, normally administrative. If a manufacturing concern, may be
included in cost of goods sold.
(h) Other expenses or losses section or in separate section, appropriately labeled as an
unusual item, if unusual or infrequent but not both.
18. Bonds and Glavine should not report the sales in a similar manner. This type of transaction
appears to be typical of Bonds’ central operations. Therefore, Bonds should report revenues of
$160,000 and expenses of $100,000 ($70,000 + $30,000). However, Glavine’s transaction
appears to be a peripheral or incidental activity not related to their central operations. Thus,
Glavine should report a gain of $60,000 ($160,000 – $100,000). Note that although the
classification is different, the effect on net income is the same ($60,000 increase).
19. You should tell Rex that a company’s reported net income is the same whether the single-step
or multiple-step format is used. Either way, the company has the same revenues, gains,
expenses, and losses; they are simply organized in a different format.
20. Both formats are acceptable. The amount of detail reported in the income statement is left to
the judgment of the company, whose goal in making this decision should be to present financial
statements which are most useful to decision makers. We want to present a simple,
understandable statement so that a reader can easily discover the facts of importance;
therefore, a single amount for selling expenses might be preferable. However, we also want to
fully disclose the results of all activities; thus, a separate listing of expenses may be preferred.
Note that if the condensed version is used, it should be accompanied by a supporting schedule
of the eight components in the notes to the financial statements.
5-7
Questions Chapter 5 (Continued)
21. Intraperiod tax allocation should not affect the reporting of an unusual gain. The FASB
specifically prohibits a “net-of-tax” treatment for such items to insure that users of financial
statements can easily differentiate extraordinary items from material items that are unusual or
infrequent, but not both. “Net-of-tax” treatment is reserved for discontinued operations,
extraordinary items, cumulative effect of a change in accounting principle, and prior period
adjustments.
22. Intraperiod tax allocation has no effect on reported net income, although it does affect the
amounts reported for various components of income. The effects on these components offset
each other so net income remains the same. Intraperiod tax allocation merely takes the total
tax expense and allocates it to the various items which affect the tax amount.
23. If Letterman has preferred stock outstanding, the numerator in its computation may be
incorrect. A better description of “earnings per share” is “earnings per common share.” The
numerator should include only the earnings available to common shareholders. Therefore, the
numerator should be: net income less preferred dividends.
The denominator is also incorrect if Letterman had any common stock transactions during the
year. Since the numerator represents the results for the entire year, the denominator should
reflect the weighted average number of common shares outstanding during the year, not the
shares outstanding at one point in time (year-end).
24. The earnings per share trend is not favorable. Extraordinary items are one-time occurrences
which are not expected to be reported in the future. Therefore, earnings per share on income
before extraordinary items is more useful because it represents the results of ordinary business
activity. Considering this EPS amount, EPS has decreased from $7.21 to $6.40.
25. Tax allocation within a period is the practice of allocating the income tax for a period to such
items as income before extraordinary items, extraordinary items, and prior periods adjustments.
The justification for tax allocation within a period is to produce financial statements which
disclose an appropriate relationship, for example, between income tax expense and (a) income
before extraordinary items, (b) extraordinary items, and (c) prior periods adjustments (or of the
opening balance of retained earnings).
26. Tax allocation within a period (intraperiod) becomes necessary when a firm encounters such
items as discontinued operations, extraordinary items, accounting changes, or adjustments of
prior periods (that is, of the opening balance of retained earnings). Such allocation is
necessary to bring about an appropriate relationship between income tax expense and income
from continuing operations, discontinued operations, income before extraordinary items,
extraordinary items, etc.
Tax allocation within a period is handled by first computing the tax expense attributable to
income before extraordinary items, assuming no discontinued operations. This is simply
computed by ascertaining the income tax expense related to revenue and expense
transactions entering into the determination of such income. Next, the remaining income tax
expense attributable to other items is determined by the tax consequences of transactions
involving these items. The applicable tax effect of these items (extraordinary, accounting
changes, prior period adjustments) should be disclosed separately because of their materiality.
5-8
Questions Chapter 5 (Continued)
27.
Natsume Sozeki Company
Partial Income Statement
For the Year Ended December 31, 2003
Income before taxes and extraordinary item $1,000,000
Income taxes 340,000
Income before extraordinary item 660,000
Extraordinary item—gain on sale of plant (condemnation) $450,000
Less applicable income tax 135,000 315,000
Net income $ 975,000
28. The damages would probably be reported in Pierogi Corporation’s financial statements in the
other expenses or losses section. If the damages are unusual in nature, the damage
settlement might be reported as an unusual item. The damages would not be reported as a
prior period adjustment.
29. The assets, cash flows, results of operations, and activities of the plants closed would not
appear to be clearly distinguishable, operationally or for financial reporting purposes, from the
assets, results of operations, or activities of the Tiger Paper Company. Therefore, disposal of
these assets is not considered to be a disposal of a component of a business that would
receive special reporting.
30. The major items reported in the retained earnings statement are: (1) adjustments of the
beginning balance for prior period adjustments, (2) the net income or loss for the period, (3)
dividends for the year, and (4) restrictions (appropriations) of retained earnings. It should be
noted that the retained earnings statement is sometimes composed of two parts,
unappropriated and appropriated.
31. Generally accepted accounting principles are ordinarily concerned only with a “fair
presentation” of business income. In contrast, taxable income is a statutory concept which
defines the base for raising tax revenues by the government, and any method of accounting
which meets the statutory definition will “clearly reflect” taxable income as defined by the
Internal Revenue Code. It should be noted that the Code prohibits use of the cash receipts and
disbursements method as a method which will clearly reflect income in accounting for
purchases and sales if inventories are involved.
The cash receipts and disbursements method will not usually fairly present income because:
1. The completed transaction, not receipt or disbursement of cash, increases or diminishes
income. Thus, a sale on account produces revenue and increases income, and the
incurrence of expense reduces income without regard to the time of payment of cash.
2. The matching principle requires that costs be matched against related revenues produced.
In most situations the cash receipts and disbursements method will violate the matching
principle.
3. Consistency requires that accountable events receive the same accounting treatment from
accounting period to accounting period. The cash receipts and disbursements method
permits manipulation of the timing of revenues and expenses and may result in treatments
which are not consistent, detracting from the usefulness of comparative statements.
32. Problems arise both from the revenue side and from the expense side. There sometimes may
be doubt as to the amount of revenue under our common rules of revenue recognition.
However, the more difficult problem is the determination of costs expired in the production of
revenue. During a single fiscal period it often is difficult to determine the expiration of certain
5-9
Questions Chapter 5 (Continued)
costs which may benefit several periods. Business is continuous and estimates have to be
made of the future if we are to systematically apportion costs to fiscal periods. Examples of
items which present serious obstacles include such items as institutional advertising and
organization costs.
Accountants have established certain rules for handling revenues and costs which are applied
consistently and in a systematic manner. From period to period, application of these rules
generally results in a satisfactory matching of costs and revenues unless there are large
changes from one period to another. These rules, influenced by conservatism in the face of the
uncertainties involved, tend to charge costs to expense earlier than might be ideally desirable if
we had more knowledge of the future.
Costs or expenses of the types mentioned above, by their very nature, defy any attempt to
relate them to revenues of a specific period or periods. Although it is known that institutional
advertising will yield benefits beyond the present, both the amount of such benefits and when
they will be enjoyed are shrouded in uncertainty. The degree of certainty with which their time
distribution can be forecast is so small and the results, therefore, so unreliable that the
accountant writes them off as applicable to the period or periods in which the expense was
incurred.
33. Components are the major subsections of an income statement such as income from
continuing operations, income from discontinued operations, other revenues and gains, etc.
Elements are the basic ingredients which comprise the income statement; that is, revenues,
gains, expenses, and losses. Items are descriptions of the elements such as rent revenue, rent
expense, etc.
In order to predict the future, the amounts of individual items may have to be reported. For
example, if “income from continuing operations” is significantly lower this year and is reported
as a single amount, users would not know whether to attribute the decrease to a temporary
increase in an expense item (for example, an unusually large bad debt), a structural change
(for example, a change in the relationship between variable and fixed expense), or some other
factor. Another example is income data that are distorted because of large discretionary
expenses.
34. Other comprehensive income must be displayed (reported) in one of three ways: (1) a second
separate income statement, (2) a combined income statement of comprehensive income, or (3)
as part (separate columns) of the statement of stockholders’ equity.
35. The results of continuing operations should be reported separately from discontinued
operations, and any gain or loss from disposal of a component of a business should be
reported with the related results of discontinued operations and not as an extraordinary item.
The following format illustrates the proper disclosure:
Income from continuing operations before income taxes $XXX
Income tax expense XXX
Income from continuing operations XXX
Discontinued operations
Gain (loss) on disposal of Division X
(less applicable income taxes of $—) XXX
Net income $XXX
5-10
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 5-1
Tim Allen Co.
Income Statement
For the Year 2003
Revenues
Sales $540,000
Expenses
Cost of Goods Sold $320,000
Wages Expense 120,000
Other Operating Expenses 10,000
Income Tax Expense 25,000
Total Expenses 475,000
Net income $65,000
Earnings per share $0.65
5-11
BRIEF EXERCISE 5-2
Turner Corporation
Income Statement
For the Year Ended December 31, 2004
Revenues
Net sales $2,400,000
Interest revenue 31,000
Total revenues 2,431,000
Expenses
Cost of goods sold $1,250,000
Selling expenses 280,000
Administrative expenses 212,000
Interest expense 45,000
Income tax expense* 193,200
Total expenses 1,980,200
Net income $ 450,800
Earnings per share** $6.44
*($2,431,000 – $1,250,000 – $280,000 – $212,000 – $45,000) X 30% =
$193,200.
**$450,800 ÷ 70,000 shares.
BRIEF EXERCISE 5-3
Turner Corporation
Income Statement
For the Year Ended December 31, 2004
Net sales $2,400,000
Cost of goods sold 1,250,000
Gross profit 1,150,000
Selling expenses $280,000
Administrative expenses 212,000 492,000
Income from operations 658,000
