CHAPTER 4
Income Statement and Related Information
LEARNING OBJECTIVES
1. Understand the uses and limitations of an income statement.
2. Understand the content and format of the income statement.
CHAPTER REVIEW
1. Chapter 4 presents a detailed discussion of the concepts and techniques that underlie the
2. (L.O. 1) The income statement helps users of financial statements (1) evaluate the past
performance of the company, (2) provide a basis for predicting future performance, and
(3) help assess the risk or uncertainty of achieving future cash flows. The limitations of
3. Quality of earnings is important because markets are based on trust and it is imperative
that investors have faith in the numbers reported. If that trust is damaged, capital markets
Format of the Income Statement
4. (L.O. 2) The two major elements of income statement are income and expenses. The
5. Intermediate components of the income statement include some or all of the subtotals within
the income statement to arrive at net income/loss including: gross profit, income from
operations, income before income tax, and income from continuing operations.
6. (L.O. 3) The following items are required to be presented on the income statement:
7. An income statement is composed of various sections that relate to different aspects of
the earning process. Companies may prepare some or all of the following sections.
a. Sales or revenue section.
h. Discontinued Operations. Gains and losses resulting from disposal of a component
of a company.
8. A company includes only the totals of components in condensed income statements, but
prepare supplementary schedules to support the totals.
Reporting within the Income Statement
9. (L.O. 4) Companies are required to present expenses classified either by their nature
10. The IASB takes the position that both revenues and expenses and other income and
11. When the parent company’s interest in the subsidiary company is less than 100 percent
the ownership of the subsidiary is divided into (a) the majority interest who own the
controlling interest and (b) the non-controlling interest (the minority interest).
12. (L.O. 5) In general, earnings per share represents the ratio of net income minus
preference dividends (income available to common shareholders) divided by the weighted
13. The IASB defines a discontinued operation as a component of an entity that either has
been disposed of or is classified as held-for-sale, and (a) represents a major line of
business or geographical area of operations, or (b) is part of a single, coordinated plan to
14. (L.O. 6) Intraperiod tax allocation is the process of relating the income tax effect of an
statement or in a footnote.
Other Reporting Issues
15. (L.O. 7) A change in accounting principle results when a company adopts a new
accounting principle that is different from the one previously used. A company recognizes a
16. Accountants make extensive use of estimates in preparing financial statements. Adjustments
that grow out of the use of estimates in accounting are used in the determination of
17. Companies must correct errors by making proper entries in the accounts and reporting
corrections in the financial statements. Corrections of errors are treated as prior period
18. (L.O. 8) The retained earnings statement serves to reconcile the balance of the retained
earnings account from the beginning to the end of the year. The important information
19. (L.O. 9) Items that bypass the income statement are included under the concept of
comprehensive income. Comprehensive income includes all changes in equity during
20. The statement of changes in equity is required by the IASB and reports the change in
share capital, retained earnings, and the accumulated balances in other comprehensive
LECTURE OUTLINE
The material in this chapter can be covered in two to three class sessions. Most students have
had previous exposure to the concepts presented in the chapter.
The lecture and assigned problems should be directed toward two areas of concentration:
1. An understanding of each of the intermediate components of income and other unusual
2. An understanding of proper format for income (including comprehensive income) and
retained earnings statements. Given transaction data or account balances, students should
The material in the chapter can be presented with the following lecture outline:
A. (L.O. 1) Usefulness of the Income Statement.
1. Income information helps interested parties predict the amounts, timing, and uncertainty
of future cash flows. Income information is useful:
a. for evaluating past performance.
B. Limitations of the Income Statement.
1. Companies omit items from the income statement that they cannot measure
reliably. For example:
3. Income measurement involves judgment. Discuss this in terms of bad debt expense
and depreciation expense.
C. Quality of Earnings
D. (L.O. 2) Income Statement Format: Disclosure of the Intermediate Components of Income.
2. Presentation of income statement items.
a. Income statement components.
E. (L.O. 4) Reporting within the Income Statement.
1 Companies may prepare a condensed income statement with details on various com–
ponents presented in the notes to the financial statements.
2. Companies are required to present an analysis of expenses classified either by their
nature or their function.
4. When the parent company’s share interest is less than 100%, the subsidiary is only
partially owned. Under this arrangement, the subsidiary’s ownership is divided into (1)
F. (L.O. 5) Earnings Per Share—a widely used measure of business performance.
1. Discuss the importance of EPS in the financial press using examples from The Wall
Street Journal.
2. EPS is equal to
3. Per share figures must be disclosed in the income statement for the following amounts:
4. Discontinued operations. Disposals of a component are reported net of tax in the
income statement immediately below income from continuing operations. Results of
the disposal are reported in two amounts.
G. (L.O. 6) Intraperiod Tax Allocation—the process of associating income tax expense with
related income. The principle is “let the tax follow the income.”
1. Intraperiod tax allocation involves a breakdown of total income tax expense into
separate components which are disclosed on different portions of the financial
2. Use the income statement from Illustration 4.11 on text page 4-15 to demonstrate
intraperiod tax allocation. Ask students to compute the total tax expense for 2019. It is
$167,800, disclosed for accounting purposes as follows:
3. Point out that the net-of-tax amount of an item is calculated by multiplying the item by
(1 minus the tax rate).
H. (L.O. 7) Changes in Accounting Principle—adoption of an accounting method that is
different from the one previously used.
1. Examples:
3. Recast prior years’ statements to reflect new principle.
4. Point out that it is the cumulative effect of the change on prior years’ income that is
I. Changes in Estimates (Normal, Recurring Corrections and Adjustments)—
adjustments that result from periodic revisions in estimates.
1. Examples.
2. These adjustments are not treated as errors. Students frequently misunderstand this.
They erroneously believe that special journal entries or separate disclosures must be
made.
J. Correction of errors.
1. Examples.
a. Mathematical mistakes.
K. (L.O. 8) Retained Earnings Statement—a summary disclosure of the changes in the
balance of the Retained Earnings account from the beginning to the end of the year. The
following items are disclosed in the retained earnings statement:
1. Prior period adjustments. Adjustments to the beginning balance of retained earnings.
a. Transactions that are accounted for as prior period adjustments:
(1) Correction of errors in financial statements of prior periods.
2. Dividends and net income.
3. Restrictions of retained earnings.
L. (L.O. 9) Comprehensive Income—includes all changes in equity during a period except
those resulting from investments by owners and distributions to owners.
1. Other comprehensive income—includes those gains and losses that bypass net
income but affect stockholders’ equity (i.e., unrealized gains and losses on available–
for-sale securities).
3. Statement of changes in equity—reports the change in share capital, retained earnings
and the accumulated balances in other comprehensive items.