978-1259722660 Chapter 4 Lecture Note Part 1

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CHAPTER 4

THE INCOME STATEMENT, COMPREHENSIVE INCOME, AND THE

STATEMENT OF CASH FLOWS

Overview

This chapter has a threefold purpose:

(1) To consider important issues dealing with the content, presentation, and disclosure of net

income and other components of comprehensive income. 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 other items that

are not part of net income but are considered other comprehensive income items instead.

(2) To provide an overview of the statement of cash flows, which is covered in depth in Chapter

21. 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.

(3) To examine common ratios used to assess a company’s profitability.

Learning Objectives

LO4–1 Discuss the importance of income from continuing operations and describe its

components.

LO4–2 Describe earnings quality and how it is impacted by management practices to alter reported

earnings.

LO4–3 Discuss the components of operating and nonoperating income and their relationship to

earnings quality.

LO4–4 Define what constitutes discontinued operations and describe the appropriate income

statement presentation for these transactions.

LO4–5 Discuss additional reporting issues related to accounting changes, error corrections, and

earnings per share (EPS).

LO4–6 Explain the difference between net income and comprehensive income and how we

report components of the difference.

LO4–7 Describe the purpose of the statement of cash flows.

LO4–8 Identify and describe the various classifications of cash flows presented in a statement of

cash flows.

LO4–9 Discuss the primary differences between U.S. GAAP and IFRS with respect to the

income statement, statement of comprehensive income, and statement of cash flows.

LO4–10 Identify and calculate the common ratios used to assess profitability.

Lecture Outline

Part A: The Income Statement and Comprehensive Income

I. Income from Continuing Operations

A. Income from continuing operations includes the revenues, expenses, gains, and losses that

will probably continue in future periods.

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1. Revenues are inflows of resources resulting from providing goods or services to

customers. Expenses are outflows of resources incurred while generating revenue.

Gains and losses are increases or decreases in equity from peripheral or incidental

transactions of an entity.

2. A distinction often is made between operating and nonoperating income. Operating

income includes revenues and expenses directly related to the primary

revenue-generating activities of the company. Nonoperating income relates to

peripheral or incidental activities of the company.

3. Income tax expense always is shown as a separate expense.

4. A single-step income statement format groups all revenues and gains together and all

expenses and losses together.

5. A multiple-step income statement format includes a number of intermediate subtotals

before arriving at income from continuing operations.

6. There are more similarities than differences between income statements prepared

according to U.S. GAAP and those prepared applying IFRS.

II. Earnings Quality

A. Earnings quality refers to the ability of reported earnings (income) to predict a company’s

future earnings.

1. To enhance predictive value, analysts try to separate a company’s temporary earnings

from its permanent earnings.

2. Many believe that corporate earnings management practices reduce the quality of

earnings. Two major methods used by managers to manipulate income are (1) income

smoothing and (2) classification shifting.

B. Not all items included in operating income should be considered indicative of a company’s

permanent earnings.

1. Restructuring costs include costs associated with shutdown or relocation of facilities

or downsizing of operations. GAAP requires these costs to be expensed in the

period(s) incurred.

2. Asset impairment losses, inventory write-down charges, losses from natural disasters

such as earthquakes and floods, and gains and losses from litigation settlements are

other operating expenses that call into question the issue of earnings quality.

3. Earnings quality is affected by revenue issues as well.

C. Some nonoperating items have generated considerable discussion with respect to earnings

quality, notably gains and losses generated from the sale of assets.

D. Many companies voluntarily announce non-GAAP earnings when they report quarterly or

annual GAAP earnings. Non-GAAP earnings exclude certain expenses and sometimes

certain revenues. Non-GAAP earnings are controversial because determining which

expenses to exclude is at the discretion of management.

III. Discontinued Operations

A. Discontinued operations involve the disposal or planned disposal of a component of an

entity.

1. Discontinued operations must be reported separately, below income from continuing

operations.

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2. The objective is to report all of the income effects of a discontinued operation

separately. That’s why we include the income tax effect in this separate presentation

rather than report it as part of income tax expense related to continuing operations. The

process of associating income tax effects with the income statement components that

create those effects is referred to as intraperiod tax allocation.

B. What constitutes a discontinued operation?

1. A component of an entity or group of components has been sold or disposed of, or is

considered held for sale,

2. Whether the disposal represents a strategic shift that has, or will have, a major effect

on a company’s operations and financial results.

C. Reporting discontinued operations

1. When the component has been sold, the income effects of a discontinued operation

include (1) the operating income or loss of the component from the beginning of the

reporting period to the disposal date and (2) the gain or loss on disposal.

2. When the component is considered held for sale, the income effects of a discontinued

operation include (1) the operating income or loss of the component from the

beginning of the reporting period to the end of the reporting period and (2) an

impairment loss if the book value, sometimes called carrying value or carrying

amount, of the assets of the component is more than its fair value minus cost to sell.

3. The assets and liabilities of a component considered held for sale are reported

separately in the balance sheet at the lower of their book value or fair value minus cost

to sell.

IV. Accounting Changes

A. Accounting changes fall into one of three categories: (1) a change in an accounting

principle, (2) a change in estimate, or (3) a change in reporting entity.

B. Sometimes the FASB requires (mandates) a change in accounting principle. These changes

in accounting principles potentially hamper the ability of external users to compare

financial information among reporting periods because information lacks consistency. The

changes are accounted for in various ways:

1. Retrospective approach. The new standard is applied to all periods presented in the

financial statements as if the new accounting method had been used in those prior

periods.

2. Modified retrospective approach. The new standard is applied to the adoption period

only, and prior period financial statements are not restated.

3. Prospective approach. No modification is made to prior period financial statements.

Instead, the change is simply implemented in the current period and all future periods.

C. Sometimes companies voluntarily change accounting principles. These changes usually

are accounted for retrospectively.

D. A change in depreciation, amortization, or depletion method is considered to be a change

in accounting estimate that is achieved by a change in accounting principle. These changes

are accounted for prospectively, exactly as we would account for any other change in

estimate.

E. A change in accounting estimate is reflected in the financial statements of the current

period and future periods.

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V. Correction of Accounting Errors

A. Errors discovered in the same year they are made are simply corrected by journal entry.

B. Treatment of errors discovered in a year subsequent to the year the error is made depends

on whether the error is material.

1. If the error is not material, it is simply corrected in the year discovered.

2. If the error is material, the correction is considered a prior period adjustment, which

requires an addition to or reduction in beginning retained earnings and a restatement of

previous years’ financial statements.

VI. Earnings per Share

A. Earnings per share (EPS) is the amount of income reported during a period for each share

of common stock outstanding.

B. All corporations whose common stock is publicly traded must disclose EPS.

C. Basic EPS is calculated as net income (less any dividends to preferred shareholders)

divided by weighted common shares outstanding for the year.

D. Diluted EPS accounts for the dilution effect (reduction) in EPS for the potential increase in

common shares outstanding because the company has other instruments that could be

converted into common shares or the company has stock options outstanding that could be

exercised.

E. The EPS for (a) income from continuing operations, (b) discontinued operations, and (3)

net income must be disclosed.

VII. Comprehensive Income

A. The purpose of the income statement is to summarize the profit-generating activities that

occurred during a particular reporting period.

B. Comprehensive income is the total change in equity for a reporting period other than that

from transactions with owners.

C. Comprehensive income = Net income + Other comprehensive income

D. 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.

E. 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.

Part B: The Statement of Cash Flows

I. Usefulness of the Statement of Cash Flows

A. The purpose of the statement of cash flows (SCF) is to provide information about cash

receipts and cash disbursements that occurred during a period.

B. A SCF is presented for each period in which results of operations are provided.

II. Classifying Cash Flows

A. The SCF classifies all transactions affecting cash into one of three categories:

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1. Operating activities are inflows and outflows of cash related to the transactions

entering into the determination of net operating income, other than those involving

investing or financing activities. There are two approaches to calculating operating

activities:

a. The direct method

b. The indirect method

2. Investing activities involve the acquisition and sale of (1) long-term assets used in the

business and (2) nonoperating investment assets.

3. Financing activities involve cash inflows and outflows from transactions with creditors

(excluding trade creditors) and owners.

B. Significant investing and financing transactions not involving cash also are reported.

C. The classification of certain cash flows differs between U.S. GAAP and international

accounting standards.

Part C: Profitability Analysis

I. Activity Ratios

A. Activity ratios measure a company’s efficiency in managing its assets.

B. The asset turnover ratio measures a company’s efficiency in using assets to generate

revenue and is calculated by dividing a company’s net sales or revenues by the average

total assets available for use during the period.

C. The receivables turnover ratio offers an indication of how quickly a company is able to

collect its accounts receivable.

1. The ratio is calculated by dividing a period’s net credit sales by the average net

accounts receivable.

2. An extension of this ratio is the average collection period, which is computed by

dividing 365 days by the receivables turnover ratio.

D. The inventory turnover ratio measures a company’s efficiency in managing its investment

in inventory.

1. The ratio is calculated by dividing the period’s cost of goods sold by the average

inventory balance.

2. An extension of this ratio is the average days in inventory, which is computed by

dividing 365 days by the inventory turnover ratio.

II. Profitability Ratios

A. Profitability ratios assist in evaluating various aspects of a company’s profit-making

activities.

B. The profit margin on sales measures the amount of net income achieved per sales dollar

and is computed by dividing net income by net sales.

C. The return on assets (ROA) indicates a company’s overall profitability.

1. It is calculated by dividing net income by average total assets.

2. The return on assets can also be computed by multiplying the profit margin on sales by

the asset turnover.

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D. The return on shareholders’ equity measures the return to suppliers of equity capital. It is

calculated by dividing net income by average shareholders’ equity.

III. Profitability Analysis—An Illustration

A. The DuPont framework helps identify how profitability, activity, and financial leverage

trade off to determine return to shareholders.

Appendix 4: Interim Reporting

A. Interim reports are issued for periods of less than a year, typically as quarterly financial

statements.

B. With only a few exceptions, the same accounting principles applicable to annual reporting

are used for interim reporting.

C. Complete financial statements are not required for interim reporting, but certain minimum

disclosures are required:

1. Sales, income taxes, and net income.

2 Earnings per share.

3Seasonal revenues, costs, and expenses.

4. Significant changes in estimates for income taxes.

5. Discontinued operations and unusual items.

6. Contingencies.

7. Changes in accounting principles or estimates.

8. Information about fair value of financial instruments and the methods and assumptions

used to estimate fair values.

9. Significant changes in financial position.

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